• Audit Committees Beware: Auditors Are Required to Evaluate Your Effectiveness Under New Internal Control Auditing Standard
  • April 14, 2004
  • Law Firm: Womble Carlyle Sandridge & Rice - Winston-Salem Office
  • Last month, the Public Company Accounting Oversight Board adopted Auditing Standard No. 2, its long-awaited standard on internal control attestation engagements (the "Standard"). Although the Standard imposes numerous requirements with respect to these engagements, of key importance is the Standard's requirement that, in connection with its audit of management's assessment of the company's internal control over financial reporting, the outside auditor must evaluate the effectiveness of the audit committee's oversight of the company's financial reporting and related internal controls. The Standard may be found by clicking here.

    The Standard's Effect on Audit Committees: The Standard emphasizes that the audit committee plays an important role within the control environment. Accordingly, among the circumstances that are considered significant deficiencies and are strong indicators that a material weakness exists is ineffective oversight by the audit committee over the company's internal control over financial reporting. The aspects of the audit committee's effectiveness that are important to the auditor will depend on the circumstances, but may focus on the following:

    • The independence of the audit committee members from management;

    • The clarity of the audit committee's charter and how well the members of the audit committee understand their responsibilities;

    • The degree of audit committee involvement and interaction with the outside auditor and with the company's internal auditors;

    • The degree of audit committee interaction with key members of financial management, including the chief financial officer and chief accounting officer;

    • The extent to which the members of the audit committee demonstrate an understanding of the company's critical accounting policies and critical accounting estimates;

    • The audit committee's responsiveness to issues raised by the auditor; and

    • The audit committee's monitoring of the company's code of ethics, especially as the code relates to conflicts of interest, related party transactions and illegal acts.

    Independent auditors are not responsible for performing a separate and distinct evaluation of the audit committee under the Standard. However, the auditor must assess the effectiveness of the audit committee as part of the auditor's understanding and evaluating of the role of the audit committee within the control environment.

    Effective Date: Accelerated filers must include the report on internal control over financial reporting in Form 10-Ks for fiscal years ending on or after November 15, 2004. Other filers must include the report in Form 10-Ks or Form 10-KSBs for fiscal years ending on or after July 15, 2005.

    What to Do Now: In preparing to comply with the SEC's rules relating to reports on internal control over financial reporting, companies should not ignore the critical role of the audit committee in this process. For management to conclude that the company's internal control over financial reporting is effective, and for the outside auditor to form an opinion that management's opinion is fairly stated, it is essential that the audit committee clearly understand its responsibilities and be active and assertive in discharging them. The board of directors of every public company should evaluate how effectively its audit committee is currently functioning in the context of the Standard and promptly take any action that is necessary or appropriate to ensure that the functioning of the audit committee will not lead to a finding of a significant deficiency or a material weakness.