LIFE IN A FISHBOWL
Audit committees in the US have been under intense scrutiny - and seem to be the better for it.
By Stephen Barr

The audit committee of Brunswick, the US bowling pin manufacturer, took a very close look at one particular item during their meeting last May - the nonaudit fees paid last year to Arthur Andersen, the company's external auditor.

The US$3.3 million Andersen received for tax advice, acquisition due diligence and help with new accounting pronouncements, the committee was told, was 2.2 times more than the US$1.5 million it cost the multinational for basic audit services. But that ratio was about half the average among all of Andersen's clients. Moreover, the group of five directors, which includes a current and a retired CFO, was assured that these nonaudit fees had in no way impaired the objectivity of the Andersen auditors when they reviewed the books of the US$3.8 billion-a-year company.

To test that assertion, committee members pressed the finance executives at the meeting about their selection process for these nonaudit assignments. "We probed the staff on whether there was any quid pro quo," says Robert Ryan, CFO of US-based Medtronic, who joined Brunswick's audit committee in 1998. "We wanted them to take us through the work that was done, and explain why Andersen was the best firm for the job," he says.

Ryan was satisfied by what he heard, since the answers were much the same as he would have given under such questioning. As for Brunswick's CFO, Vicki Reich, she welcomed the scrutiny. "There is heightened sensitivity among all parties that we don't want to do anything to compromise auditor independence," she says.

And for good reason. Since February 5, US businesses have been required to disclose what they pay their accountants for information technology (IT) and certain other consulting services. And audit committees have, in turn, been called on to determine whether these nonaudit fees can make auditors' backbones go soft.

Evaluating auditor independence, however, is only the most high profile of a series of new initiatives designed to give audit committees more teeth. The impetus came from former US Securities and Exchange Commission chairman Arthur Levitt, who charged - as part of his broad-based assault on earnings management - that audit committees didn't meet enough, conducted only perfunctory reviews of financial statements, and were stacked with members who were either unqualified or too close to management. In response, a blue-ribbon panel of market regulators, accounting officials and corporate executives sought to rectify those deficiencies with new oversight requirements.

As of June, companies were expected to have addressed the last of the panel's ten proposals: that all committee members be financially literate and that at least one qualifies as a financial expert. Former SEC general counsel Harvey Goldschmid asserts that the new rules, which were originally approved in December 1999, "are achieving their purpose of having far more active audit committees."

By all available measures, Goldschmid is right. Two years ago, CFO in the US, CFO Asia's sister magazine, reviewed 150 random corporate proxies filed in 1998 to gauge the state of audit committees. It found that Levitt's critique was largely on target. This spring, we looked at a subset of that original group - only 80 filed proxies in 2001, while 42 others had either been acquired or gone out of business - and found evidence of improvement.

For instance, audit committees today meet an average of 4.6 times annually, up from 3.5 times in 1998; the blue-ribbon panel said a minimum of four meetings a year were needed to provide adequate oversight. The change was even more dramatic with regard to having only independent directors serve on the committee. In 1998, 28 percent of the companies in our survey had at least one committee member with business or personal ties that might compromise objectivity; the tally in 2001 was just 13 percent.

Improvement - albeit slight - was also found in the composition of audit committees. While they remain heavily weighted to CEOs, the percentage of companies with CFOs or other finance and accounting professionals on their committees grew from 24 in 1998 to 27 this year. Yet indications are that the numbers won't go much higher, because the new definitions of financial literacy - which are set by the stock exchanges - are overly broad, allowing any executive with financial experience to fit the bill.

Predictions cannot be made, however, about how the ratio of nonaudit fees to audit fees paid will change, since those amounts have not been previously disclosed. Levitt fretted that auditors' judgment was clouded by their firms' efforts to sell various other services, particularly related to IT. In the CFO survey, every company engaged its external auditor for some nonaudit services, such as tax advice or acquisition due-diligence support, and overall the ratio of those fees to the audit fees was 2.3 to 1. Far fewer companies hired their auditors for help on IT projects - 28 percent - but with those fees included, the ratio jumped to 5.8 to 1.

Overall, the jury is still out on whether audit committees are more effective. "There's a greater sense of responsibility and more vigilance on the part of audit committees," says former Secretary of Commerce Barbara Hackman Franklin, who serves on six audit panels and heads those at Dow Chemical, the US chemical company, and Aetna, the insurance group. "But the big question is whether these new rules will cure the management-of-earnings problem that Levitt had in his sight," she says.

Board Composition

Historically, the audit committee has been the place to stow new directors. Frequently lacking any background in finance and accounting, these directors were rarely in a position to challenge management or external auditors. No more. According to Julie Daum, managing director for board services at executive recruiter Spencer Stuart, companies are being "very careful about choosing who serves on that committee."

That choosiness has translated into an effort to ensure financial savvy among members. High-profile CFOs are receiving more offers to sit on boards than they can accept, and invariably are being recruited for the audit committee. Marie Knowles, the retired CFO of Atlantic Richfield, chairs the audit committees of three corporate boards. Robert Wayman, CFO of Hewlett-Packard, serves on the audit committee of software company Sybase and co-chairs the audit committee of Portal Software in the US. Similarly, Medtronic's Ryan was recently shifted to the audit group at UnitedHealth, and wasn't given a choice when he joined Brunswick. "I was told I was on the audit committee from day one," he says.

At the same time, there's an effort to include fewer individuals with ties to management. What connotes independence, however, can vary widely. The stock exchanges, which again set the rules, give companies leeway to have nonindependent directors on the audit committee if they believe there's no one better for the job.

But shareholder groups argue for stricter standards. "We're no longer seeing anything as egregious as having the [sitting] CFO on the audit committee," says Jamie Heard, CEO of Proxy Monitor, a shareholder advisory firm based in New York. "But some of the affiliated outsiders who may pass muster under exchange rules don't live up to our definition of independent," because of business ties. Proxy Monitor has recommended shareholder votes against 260 nonindependent directors who sit on audit committees during the current proxy season.

In all, the recent CFO survey showed that 13 percent of the companies had audit committee members with personal or business relationships to management, compared with 28 percent in 1998. In the past three years, medical equipment supplier Lincare Holdings CFO Paul Gabos stepped down from the company's audit group, as did several former CFOs, including Vincent Marafino of Lockheed
Martin.

In contrast, Apple Computer had to weigh losing veteran Jerome York, the former CFO of Chrysler and IBM, after he became CEO of MicroWarehouse, an Apple reseller. "The Board," states Apple's proxy, "determined that it is in the best interest of the company and its shareholders that he continue to serve as a member of the audit committee."

Meeting More

Improving the ties between the audit committee and the auditors is a central theme of many of the recently enacted rules. Among them is the call for the outside auditors to be accountable to the audit committee instead of management, with the directors held responsible for hiring and firing. The audit firm is now expected to have more-frequent and detailed discussions with the committee, especially around the quarterly earnings. "The biggest change for me has been the quarterly review process," says Franklin. "Before, the auditors were in the loop (with management), but the audit committee was not," she says.

For the most part, audit committees are not counting the quarterly review as an official meeting, but they are still meeting more often. In the CFO survey, the average number of meetings jumped to 4.6 annually, from 3.5 in 1998. Frank Borelli, a retired CFO of insurer Marsh & McLennan, and a corporate member of the SEC's audit committee panel, says he devotes more time now to the audit committee meetings that he chairs of two other US companies.

"The problem with audit committees [in the past] was that they were held just before board meetings; it was like a fire drill," says Borelli. "You need a relaxed atmosphere without time constrictions. We hold our meetings the afternoon before and leave at least two hours, so we can meet with the financial officers and make sure we get a feel for everything that goes into making the financial statements work," he says.

Yet skeptics still question committees' diligence. The audit committee charter and annual report that must be included in the proxy are largely boilerplate, and "seem like they were all drafted by the same law firm," says shareholder activist Nell Minow, who edits The Corporate Library, a corporate governance website.

Fees Fuss

The notion of calling on the audit committee to review auditor independence was recommended by the SEC panel in 1999. But it wasn't until late last year, when Levitt sought to ban accounting firms from performing certain nonaudit services for audit clients, that an agreement was struck to report the fees paid.

The effect of these disclosures is subject to debate. In the survey, the majority of firms describe fees for other services, such as tax advice and merger integration. Inevitably, the audit committee report in the proxies asserts that the board does not believe that auditor independence has been impaired. "Although the Company expects to continue to retain KPMG and other firms to assist in the design and implementation of its financial information systems," states the audit committee of General Electric, which paid the accounting firm US$50.4 million in IT fees in 2000, "GE managers make all management decisions with respect to such systems, and are responsible for ... establishing and maintaining the Company's system of internal accounting controls."

Finance executives tend to see a benefit from having their auditors take on nonaudit projects. "They're here, they know us, and it makes things more efficient," says Brunswick's Reich. Although Brunswick had previously hired Arthur Andersen for systems projects, Reich argues that it's important to go through a competitive bid process. "There's a point where management and the audit committee should look hard to see if someone else can do the job," she says.

Where that point lies is hard to determine. "It's a judgment call about how much is too much before the auditors' independence is impaired," says Franklin. Her rule of thumb, she says, is if the consulting fees amount to more than 50 percent of the total fees on a three-year average, it's time to take a closer look.

Overall, the nonaudit fees in our survey were 64 percent of the total accounting firm fees for the companies sampled, with almost four of ten exceeding the 75 percent threshold. Of the ten with the highest ratio, only two, Cadence Design Systems and AT&T, were hit with shareholder lawsuits in recent years. In neither case was the auditor implicated.

It may take time, but the nonaudit percentages will likely come down. "In the current environment, it's inevitable that the market will be cautious about paying large amounts of nonaudit fees to the audit firm," says Michael Cook, former CEO of Deloitte & Touche, who sits on six audit committees. "Today, we're seeing the results of relationships and contracts that were in place before the heat was turned up. In two years, you're going to see numbers of less magnitude," he says.

The Accelerating Effect

When the SEC began its push to beef up audit committees, the overriding concern among directors and corporate executives was that new rules would prompt more litigation. To date, however, the only explosion the new rules have brought has been in the amount of time and energy directors must commit to audit committees. "We just keep loading on," says Cook. "My concern is that we don't solve the problem of inadequate audit committees by driving away some of the best members," he says.

Others don't see the new tasks as a deterrent. "The role and oversight haven't extended beyond what is appropriate," says Allen Krowe, former CFO of Texaco, who chairs Navistar International's audit committee. In fact, as Krowe sees it, the new rules have had "an accelerating effect", adding more time to the job by formalizing what good audit committees have always done. "This is serious, nontrivial work," he says. "You have to be committed to doing homework and keeping up to speed." He adds: "This is not something to do because it looks good on your résumé."

Stephen Barr is senior contributing editor at CFO in the US.