March 31, 2014
Audit Committees Put on Notice
The U.S. Securities and Exchange Commission (SEC) has filed federal charges in Tennessee against the former audit committee chairman and senior executives of animal feed company AgFeed Industries Inc., in what could be a "warning shot" for public company audit committees,
Reuters reports. The SEC alleges the individuals failed to appropriately investigate an accounting fraud in their operations in China. Moreover, it accuses executives based in China of keeping two sets of books. Attorneys for former audit committee chairman K. Ivan Gothner and former chief financial officer Edward Pazdro say the charges wrongly punish the defendants, who they say had called for an internal investigation into the fraud as soon as it was detected.
It may be some time before we know how this alleged accounting fraud case will be concluded. It nonetheless offers an opportunity to reflect on one of the central issues — the obligations and accountability of audit committee chairs and company management to expeditiously deal with fraud red flags, including those identified via auditor findings. With the passage of the U.S. Sarbanes-Oxley Act of 2002, the responsibilities and roles of the audit committee and independent auditors dramatically changed. Under Sarbanes-Oxley, it is the audit committee's responsibility to oversee the independent auditor. The act essentially expanded the role of the audit committee to include, among other items, hiring, retaining, dismissing, evaluating, and compensating the independent auditor. It also required the audit committee to approve nonaudit services and monitor auditor independence issues.
Some actions audit committees and regulators can take to ensure audit committees are performing these duties include:
- Audit committees should regularly review their composition and membership to confirm that they not only encompass the knowledge and experience needed to be effective, but also retain sufficient independence necessary to advise senior management and investors regarding sensitive issues such as fraud. In addition to industry knowledge, committee members should have a strong grasp of key financial reporting and accounting issues, such as revenue recognition, pensions, and other post-employment benefits, as well as financial instruments, other critical accounting policies, and internal controls. Further, as underscored by recent SEC investigation and enforcement of the accountability of "gatekeepers" against fraud, audit committees need to remain in the forefront of knowledge and best practice about ethical, conflict of interest, governance, and accountability matters. Audit committee best practice studies also often commend the valuable advice and perspective that independent audit committee members can provide, even though they may not necessarily possess intimate, long-term company knowledge. Put differently, an excellent CEO does not necessarily make an excellent audit committee chair. In the AgFeed case, the audit committee chairman previously had been the company's CEO. Some organizations and jurisdictions have stipulated that the audit committee chair cannot be a current or former CEO, and that a minimum number of audit committee members, including the chair, be selected from outside the company.
- As I have observed previously about other fraud cases, audit committee charters must not just be considered "paper exercises" that define committee roles and responsibilities in vague and general terms. Increasingly in a world of evolving conditions and expectations, it will be important for charters to include language and requirements dealing with what committees must do to address current issues, such as those related to ethics and fraud. Both ethics and fraud have increased dramatically in the past decade and show no sign of diminishing.
- At the same time, regulators and enforcement bodies need to do more to clarify expectations, processes, time lines, and consequences for audit committees in dealing with alleged ethical and fraudulent behavior. I will neither be first nor last to observe that governments and their regulatory and enforcement bodies frequently are ambiguous about their expectations of private enterprise behavior. Yet, the corporate world moves increasingly more quickly to respond to the need to reorganize, restructure, merge, or vacate the market to deal with fast-changing market forces. If regulators desire to establish higher and more precise standards of expected audit committee behavior, they have a responsibility to consult, communicate, and educate those most affected.