AUDIT COMMITTEES: FORM OVER SUBSTANCE

Implications: This article sheds much needed light upon what I believe to be the most pervasive and significant internal control weakness among public companies…that being the absence of current and relevant technical accounting and financial reporting expertise on audit committees. As an audit committee truly serves as the last line of defense to the dissemination of erroneous or fraudulent financial reporting, it is imperative that analysts be more attentive to the technical qualifications of its members.

Analysis: Pursuant to the Sarbanes-Oxley Act of 2002 (“SOX”), a public company must either (i) have at least one member of its audit committee that qualifies as an “audit committee financial expert,” as defined, or (ii) disclose annually its basis for the absence of such an “expert.” Unfortunately, in response to the objections expressed by many companies while SOX was being drafted, Congress diluted its initially contemplated definition of “audit committee financial expert” to the point where nearly anyone with an elementary understanding of accounting, financial reporting, internal control and corporate governance qualifies. As a consequence, few audit committees have been technically strengthened from that of their pre-Enron era predecessors.

Consistent with my observations over twenty plus years of scrutinizing public companies, including nearly nine years with the SEC’s Division of Corporation Finance, very few audit committees have even one member that is truly proficient in technical accounting and financial reporting matters. Admittedly, many audit committee members have impressive biographies, commonly including tenures as audit partners with major international accounting firms or chief financial officers with public companies. Unfortunately, many of these otherwise notable individuals became increasingly consumed, out of necessity, with administrative, operational or marketing matters as their careers progressed, which inversely resulted in their technical accounting and financial reporting knowledge progressively deteriorating over the years. As a consequence, these otherwise impressive individuals, with all due respect, are rarely up to the task of monitoring and assessing the application of increasingly complex accounting and financial reporting rules and regulations.

Thus, I believe that it is imperative that analysts thoroughly scrutinize the current and relevant technical accounting and financial reporting expertise of the audit committee members of companies with which they contemplate any investment. To the extent that there is not at least one audit committee member that possesses current and relevant “real world” technical experience in assessing the application of increasingly complex accounting and financial reporting rules and regulations (i.e., a true “audit committee financial expert”), an analyst must acknowledge that the risks associated with their investment is unnecessarily elevated.