Ratify Auditors

Vote FOR management proposals to ratify auditors, unless: (1) an auditor has a financial interest in or association with the company, and is therefore not independent; (2) fees for non-audit services are excessive; (3) there is reason to believe that the independent auditor has rendered an opinion, which is neither accurate nor indicative of the company's financial position; or (4) the auditor is held accountable for poor accounting practices which rise to a level of serious concern such as: fraud, misapplication of GAAP; and material weaknesses identified in Section 404 disclosures.

Vote CASE-BY-CASE on shareholder proposals asking companies to prohibit their auditors from engaging in non-audit services (or capping the level of non-audit services).

Vote CASE-by-CASE on shareholder proposals asking for auditor firm rotation based upon:

• The tenure of the audit firm;
• The company’s establishment and disclosure of a renewal; process whereby the auditor is regularly evaluated for both audit quality and competitive price;
• The length of the rotation period advocated in the proposal;
• The number of annual Audit Committee meetings held and the number of financial experts that serve on the Audit Committee;
• Significant audit-related issues.

Discussion

U.S. companies are not legally required to allow shareholders to ratify the selection of auditors; however, a growing number are doing so. Approximately 72 percent of companies covered by ISS during the first half of 2006 sought such ratification. The figure represents an increase over 2004, when only 63 percent of companies included auditor ratification on the ballot. Typically, proxy statements disclose the name of the company auditor and that the board is responsible for selection of that firm.[1]

In other cases, a company's bylaws will provide for a shareholder vote to ratify auditors. Occasionally companies also state in the proxy that if shareholders do not ratify the selection of auditors, the board will consider switching to a new auditor. A representative of the accounting firm is usually present at the annual meeting to answer questions.

Shareholders often view ratification of auditors as one of the most "routine" votes they cast. However, a vote for an auditor is confirmation that the auditor has objectively reviewed the company's financial statements for compliance with generally-accepted accounting principles.

ISS feels strongly that shareholders should have the right to weigh in on the choice of the audit firm. It believes that all companies should put ratification on the ballot of their annual meeting.

Auditor's Report

Accurate and reliable financial reporting is critical to the integrity of financial markets. Investors need sound financial information in order to make informed investment decisions, and maintain market confidence.

All companies listed on U.S. stock markets must have their annual financial reports audited by an independent accounting firm. The report compiled by the independent auditor is intended to provide evidence to shareholders that the company's financial statements are free of material misstatement. The auditor's report examines the financial position of a company and identifies any discrepancies between the report and the company's financial statements. In turn, the board of directors' audit committee is responsible for reviewing this report and accepting its information.

Shareholders should read the auditor's report contained in the annual report to verify that the report does not raise a red flag. For example, an auditor's report may explain that a company maintains too much debt, has serious liquidity problems, or may be in danger of ceasing to exist as a going concern. While these problems may be evident from a review of the company's financial statements, an auditor's verification of such problems should be a serious warning for management and shareholders. Thus, this information can and should be used to evaluate the company's performance.

Improper Audits

Although outside auditors must put their stamp of approval on a company's financials, history has shown that an audited financial statement is no guarantee against management misstatements, aggressive accounting that is later reversed, or outright fraud. Technological advances have increased the demand for information, which, in turn, has put pressure on companies to meet Wall Street's earnings expectations. This has led to corporate attempts at "earnings management" in ways that have distorted and undermined the integrity of financial reporting.

In the past decade, accounting breakdowns have come to light at a series of high-profile companies, including the two largest bankruptcies in history, WorldCom and Enron. Although the companies involved were audited by major accounting firms, the auditors failed to detect, or even disregarded, glaring accounting problems. In fact, many of these cases sparked debate over the degree to which accounting firms could be held accountable in the case of deliberate management misstatements. In several cases, investors were able to collect damages from the accounting firm, as well as from the corporation.

Cendant: Accounting Subterfuge

Internal audits following the 1997 merger between CUC International and HFS, which created Cendant, revealed massive accounting irregularities and systematic fraud, including booking fictitious revenues, which had inflated income by $500 million. Cendant ultimately agreed to a $2.83 billion settlement with investors in what was then the largest securities settlement ever. Investors also collected $335 million from the auditor, Ernst & Young, despite the auditor's statement that, "… the best planned and performed audit may not detect material misstatements if there is intentional, collusive fraud by a company's financial management [and] it appears that efforts may have been taken to deceive the auditors." [2]

Sunbeam: Ersatz Turnaround

Improper accounting at Sunbeam occurred in an attempt to demonstrate that noted turnaround expert Al Dunlap had indeed engineered a spectacular performance for Sunbeam one year after taking control. In actuality, Sunbeam had established "cookie jar" reserves to increases losses for 1996 and inflate earnings in 1997. According to the SEC, at least $60 million of Sunbeam's $189 million in reported pre-tax earnings from operations came from accounting fraud. [3] Dunlap ultimately paid $15 million to settle class-action shareholder suits, was fined $500,000 by the SEC, and has been permanently barred from serving as a director or officer of a public company. Auditor Arthur Andersen likewise spent $110 million settling shareholder litigation over its alleged role in inflating the company’s profits.

Rite Aid: Distorted Do-overs

After back-to-back restatements covering 1997 to 1999 at Rite Aid, auditor KPMG resigned and withdrew its auditor's report for the prior three years because of its inability to rely on management's financial representations. Following a review by a new management team, the drugstore chain revealed that it had overstated earnings for 1998 and 1999 by $1.6 billion, then the largest restatement ever recorded, according to the SEC. [4] The company settled a class-action shareholder suit for $45 million in cash and $150 million in stock in August 2001, while several former executives have been indicted for fraud and obstruction of justice. Though not admitting wrongdoing, KPMG agreed in March 2003 to pay $125 million to settle shareholder lawsuits blaming it for failing to detect the company's massive accounting problems. KPMG characterized the criminal case as "a clear example of an auditing firm being victimized by company management." [5]

Waste Management: Eyes Wide Shut

From 1992 to 1996, auditor Arthur Andersen signed off on false financial statements, resulting in overstated pretax profits of $1.4 billion. Although the audit firm had documented deep flaws with Waste Management's financials, it concluded the misstatements were not significant enough to require correction. Andersen ultimately paid a $7 million fine to the SEC in June 2001, and joined Waste Management in settling a class action shareholder suit for $229 million over questionable accounting practices and professional malpractice on Andersen's part. As part of a separate $457 million securities class action settlement, Waste Management agreed to amend its audit committee charter to increase the number of committee meetings each year, require regular contacts between the committee and outside auditor, and bar former employees from serving as audit committee members for at least five years. It also agreed to declassify the board, which was approved by shareholders in 2002.

MicroStrategy: Evanescent Earnings

Contrary to years of reported profits, MicroStrategy had actually been losing money. The company had booked revenue before it was earned from 1997 through the third quarter of 1999 which, when restated, wiped out $55.8 million in earnings and led to a precipitous 62-percent drop in the stock price in one day. [6] SEC investigators questioned whether the fact that the auditor was also a reseller of MicroStrategy's products compromised its independence, and facilitated inappropriate accounting. As part of a settlement of a derivative shareholder suit, MicroStrategy had to add an independent director with finance experience to the audit committee. Auditor PricewaterhouseCoopers in 2001 settled SEC claims of financial fraud for $51 million without admitting guilt.

WorldCom Inc.: Double-barreled Books

The single largest financial fraud of all time actually came to light after a review initiated by WorldCom's audit committee. By improperly booking line costs as capital investments, the company masked losses and overstated its financial results for 2001 and part of 2002. Characterized as an orchestrated effort to mislead investors, the magnitude of the accounting irregularities soared to $11 billion. CEO Bernard Ebbers was convicted of securities fraud and conspiracy charges in 2005 and now is serving 25 years in prison. According to an internal WorldCom report, Ebbers may have been aware that the company disguised WorldCom's true operating performance by keeping dual sets of books--one for internal use and one for investors. [7] The now defunct Arthur Andersen served as the company's auditor.

Enron: The Emperor Has No Clothes

The collapse of Enron was a clear example of a massive breakdown of internal and external controls. All of the mechanisms designed to protect shareholders--the board, the audit committee, and the outside auditor--failed miserably.

Partnerships owned and operated by CFO Andrew Fastow were used to shift debt and assets off the company's balance sheet while inflating earnings. The trading giant's complicated financing schemes--little understood by many inside or outside the company--began unraveling in October 2001 when Enron reported a $618 million third-quarter loss and a $1.2 billion write-down of shareholders' equity. Earnings had to be restated back through 1997, wiping out $568 million, and the downgrading of the company's credit to junk status triggered the immediate repayment of $4 billion of off-balance-sheet debt.

Meanwhile, shareholders and employees saw their stock plummet from $80 per share at the beginning of 2001 to $0.26 by the following November. Company executives, on the other hand, made tens of millions by cashing out their stock options before the company fell into a downward spiral. Fastow, who earned $45 million from off-balance-sheet deals, was charged with fraud, conspiracy, money laundering, and obstruction of justice. He later reached a plea deal with prosecutors and was sentenced to six years in prison. Former CEO Jeffrey Skilling was convicted of fraud charges in May 2006 and now is serving a 24-year sentence. As Michigan Congressman John Dingell observed, "What we're looking at here is an example of superbly complex financial reports. They [Enron] didn't have to lie. All they had to do was to obfuscate it with sheer complexity--although they probably lied too."[8]

The collapse of Enron ultimately led to the demise of its auditor, Arthur Andersen, whose roster of accounting misadventures included Sunbeam, Waste Management, Global Crossing, Qwest, and WorldCom. Andersen, in fact, had discovered problems in Enron's 1997 financials but concluded that the $51 million in needed adjustments were not "material." [9] After being convicted for obstruction of justice by destroying documents related to its Enron audits, the accounting firm quit auditing public companies in August 2002.

Restatements Abound

Financial restatements overall have been soaring. A 2006 report by the Government Accountability Office (GAO) found that there had been 1,786 problematic restatements at U.S. companies during the four-year period between July 1, 2002, and June 30, 2006. [10] This compares to an average of 50 companies per year in the early 1990s, and about a half dozen per year in the 1980s. [11]

Notable Earnings Restatements

Company Period Reported earnings (loss) ($ millions) Restated earnings (loss) ($ millions) Change (percent) Cendant FY 1995 - 97 1Q, 2Q 1998 $1,200 $669 -44% McKesson HBOC FY 1997 - 99 $793 $602 -24% MicroStrategy 1Q - 3Q 1999 $8.8 $-17 -289% Pacific Gateway Exchange FY 1999 $9.5 $8 -16% Rite Aid FY 1998, 1999 $450 $-609 -235% Sunbeam FY 1997 $109 $38 -65%

Source: Institutional Investor: "Bending the Rules," by Justin Schack, August 2000

Auditor Independence

As evidenced by recent history, one thing that cannot be overstated is the auditor's critical role in safeguarding investor interests. Independent auditors have an important public trust, for it is the auditor's impartial and professional opinion that assures investors that a company's financial statements are accurate. Therefore, auditor independence from the firm being audited is essential to ensure objectivity and reduce the potential for abuse. As observed by Warren Buffett, "… auditors should regard the investing public as their client ..."[12]

Accounting Firms' Conflicts of Interest

The accounting industry has undergone a dramatic transformation in recent years. Not only have firms turned into international networks, they have become multi-disciplinary in the services offered to include broad-based consulting, particularly lucrative information technology (IT) services. As a result, individual auditors are pressured to be both "rainmakers" for new business, as well as financial watchdogs. Although accounting firms insist that these additional services can improve audits by enhancing their familiarity with the client, consulting practices, when operated side-by-side with the accounting business, can lower auditor objectivity.

The recent wave of accounting scandals point to some of the inherent conflicts between audit and non-audit services, as does the practice of revolving-door employment. From 1991 to 1997, Waste Management paid Arthur Andersen $7.5 million in audit fees and $17.8 million for non-audit work, including $6 million to Andersen Consulting. [13] And from 1971 to 1997, all of Waste Management's chief financial officers and chief accounting officers were former Andersen auditors. [14] Global Crossing and Qwest Communications International, both accused of inflating revenues using capacity swaps, also had auditor-related conflicts. Qwest paid high non-audit fees to Arthur Andersen in 2001 ($10.5 million in non-audit versus $1.4 million in audit services), while Global Crossing's executive vice president of finance was a former Andersen employee that led the audit team for the company's account.

Andersen similarly earned more money from Enron through its consulting services than from its audits. Although consulting work accounted for only a little more than half of its fees in 2001, Enron offered a potential income stream of $50 million to $100 million from future consulting engagements. Enron was also one of Andersen's largest clients, and the company routinely recruited executives, including its CFO and chief accounting officer, from Andersen or other major accounting firms.

Equally notable in Enron's case is that the company had outsourced its internal audit department to Andersen, putting the accounting firm in the dubious position of serving as both inside and outside auditor. [15] According to a 1996 Wall Street Journal report, the major accounting firms had doubled or tripled their "double duty" work over the previous five years. [16]

Regulatory Reaction

The Enron implosion and subsequent rash of accounting misdeeds and corporate failures prompted Congress to enact the Sarbanes-Oxley Act (SOX) in July 2002 to address corporate accountability, improve accounting integrity, and restore investor confidence.

As a start, SOX did away with the accounting industry's self-regulation through the Public Oversight Board (POB) and periodic peer reviews among audit firms. [17] Instead, it put the industry under tighter federal monitoring by setting up the Public Company Accounting Oversight Board (PCAOB), a private entity funded by annual issuer support fees and subject to SEC regulation and oversight. The five-member board, appointed by the SEC, is responsible for establishing accounting rules and supervising the audit practices of companies that are subject to securities laws.

Sarbanes-Oxley created additional standards for companies, along with stiffer criminal penalties, including fines and jail terms, for accounting fraud:

1. CEOs and CFOs must certify the veracity of the financial statements and must disgorge any bonuses or other incentive-based compensation and profits received during the year prior to any restatements due to misconduct or non-compliance with reporting requirements;
2. Companies must adopt a code of ethics for the CEO and senior financial officers;
3. Companies are barred from making personal loans to officers and directors (other than bank and consumer credit loans in the normal course of business); and
4. Insiders must report any trading in the company's securities within two business days. No trading is permitted during blackout periods imposed under a company's retirement plans.

To fulfill the mandate of Sarbanes-Oxley, the SEC adopted final rules in January 2003 to strengthen auditor independence and require additional disclosures to investors about the services provided by accountants. The final SEC rules, which in some respects exceed the law's requirements, include the following:

• Non-audit services: Auditors are barred from certain types of non-audit work that would impair an accounting firm's independence.

• Disclosure of auditor fees: Fees must be delineated for audit, audit-related, tax, and other services for the last two fiscal years.

• Pre-approval of auditor services: The audit committee must pre-approve all audit and non-audit services provided by the auditor.

• Rotation of audit partners: Certain partners on the audit engagement team must rotate every five to seven years, with a two- to five-year time out. (See "Changing the Auditor").

• Audit partner compensation: Accounting firms may not base audit partners' compensation on the sale of non-audit services to client companies (though they may share in the overall profits of the audit firm).

• No revolving door: Audit engagement team members (generally the lead or concurring partner) must cool off for a year before accepting employment with the client company in a "financial reporting oversight role," such as director, CEO, president, COO, CFO, general counsel, chief accounting officer, controller, treasurer, director of internal audit, or director of financial reporting. (The SEC rules go further than Sarbanes-Oxley, which restricted only four positions at client companies.)

• Communications with audit committee members: Prior to filing its audit report, the auditor must communicate to the audit committee (1) all critical accounting policies and practices to be used, (2) all alternative treatments within GAAP for policies and practices related to material items, and (3) communications between management and the auditor that are material to the financial statements.

Auditor Services

Following the auditing failures at Sunbeam, Cendant, MicroStrategy, and Waste Management, the SEC adopted new auditor independence rules in December 2000 using a disclosure-based approach. Under these rules, public companies have to disclose in their annual proxy statements the fees for audit, information technology (IT) consulting, and all other services provided by their auditors in the previous year. Audit committees are also required to state that they had considered whether the provision of non-audit services was compatible with maintaining the auditor's independence.

Based on 2001 proxy filings for over half of the Fortune 1000 companies, the SEC found that on average, for every $1.00 in audit fees paid, issuers paid $2.69 in non-audit services. The 10 companies with the highest IT consulting fees paid multiples of 3.6 to 32.3 times their audit fees. [18]

In July 2002, the Sarbanes-Oxley Act tightened the rules by prohibiting the following ten categories of services by auditors:

• Bookkeeping;
• Financial information systems design and implementation;
• Appraisal or valuation services, fairness opinions, or contribution-in-kind reports;
• Actuarial services;
• Internal audit outsourcing services;
• Management functions;
• Human resources;
• Broker or dealer, investment advisor, or investment banking services;
• Legal services; and
• Expert services unrelated to the audit

The SEC also modified its disclosure rules by requiring issuers to break out fees paid to their auditors for the past two years into four categories:

1. Audit services: Services connected to the statutory and regulatory filings including comfort letters, statutory audits, attest services, consents, and assistance with or review of documents filed with the SEC.
2. Audit-related services: Assurance or due diligence services, including employee benefit plan audits, due diligence related to M&A, accounting consultations and audits in connection with acquisitions, internal control reviews, attest services not required by law, and consultation accounting and reporting standards
3. Tax services: Tax compliance, tax planning, and tax advice. Compliance includes preparation of tax returns, claims for refunds, and tax payment planning. Planning and advice includes assistance with tax audits and appeals, tax advice related to M&A and employee benefit plans, and requests for rulings or technical advice from taxing authorities
4. Other services: All other services including any remaining financial information systems design and implementation.

The more detailed disclosures benefit both issuers and shareholders by enhancing transparency. Many companies had argued that the SEC's definition of "audit services" had been too narrowly construed, resulting in many services relating to the audit falling under the "other services" category. As a result, a number of companies began voluntarily breaking out their "other" fees in their proxy statements.

Tax Services

Although Sarbanes-Oxley does not expressly prohibit tax services, certain functions such as designing or recommending tax shelters or tax avoidance schemes could pose conflicts of interest, because they involve an audit firm auditing its own work (i.e., advising companies on how to cut their tax bills and then judging the effect on the financial statements). They also may entail an auditor becoming an advocate for the client's position on novel tax issues or assuming a management function.

In addition, tax services are one of the largest and most lucrative non-audit services provided by audit firms. Tax shelter sales in particular proliferated in the 1990s, allowing accountants to charge clients fees equal to ten to 40 percent of the amount they saved in taxes. (The SEC banned such contingent fees in 2000). [19]

The SEC backed off from restricting tax shelter work because of the difficulty of defining tax shelters, which is the purview of the Internal Revenue Service. Instead, it will leave it up to company audit committees to "strictly scrutinize" whether the auditor can fairly evaluate the firm's accounting if it performs certain tax planning and consulting services. Some companies have, in fact, established policies and procedures to prevent conflicts of interest. For example, Cisco Systems and NOVA Chemicals require that all tax-driven initiatives performed by their audit firms be reviewed by a third party.

Tax shelter abuses also came under greater scrutiny. A report by Congress’ Joint Committee on Taxation showed how Enron avoided paying any taxes from 1996 to 1999 while claiming to shareholders it had earned $2.1 billion in profits. [20] Executives of Tyco International were also implicated in questionable tax dodges, while Sprint’s two top officers stepped down in February 2003 over controversial tax schemes-set up by company auditor Ernst & Young--designed to shield $100 million in stock option gains from taxes. Meanwhile, in an effort to combat tax evasion, the Treasury Department issued regulations in February 2003 requiring corporate and individual taxpayers, as well as tax shelter promoters and tax advisors, to disclose their participation in potentially abusive tax shelters.

Empirical Studies

Although fees paid to auditors are not a sure predictor of future accounting problems, outsized non-audit fees suggest that the audit firm's independence could be compromised. If the auditor is economically bound to its corporate client for a variety of services, it might go easy on the company's audit or turn a blind eye to aggressive accounting or other questionable practices.

Studies examining the relationship between auditor services and auditor independence have produced mixed results. A 2002 academic paper found no evidence that non-audit service fees impair auditor objectivity, as measured by the auditor's propensity to issue going concern opinions. It did find, however, that audit firms are more likely to issue going concern opinions to clients paying higher audit fees, suggesting greater independence toward those clients. [21]

In contrast, a study by the MIT Sloan School of Management showed that firms paying high non-audit fees are more likely to engage in earnings management. Stock market reactions to the disclosure of non-audit fees also indicate that investors associate non-audit fees with lower quality audits and, by implication, lower quality earnings. [22]

Audit committee characteristics also play a role in the magnitude of both audit and non-audit fees. According to a 2001 study, non-audit fee ratios are significantly lower in firms that have independent and active audit committees. [23]

ISS' Approach to Fees

ISS believes that company auditors should focus on the audit function, and it will examine fee disclosures in the proxy statement to determine if non-audit fees are excessive. In making this assessment, ISS will apply the following formula based on the SEC's disclosure designations (outlined above):

Non-audit (other) fees > audit fees + audit-related fees + tax compliance/preparation fees

Among tax services, ISS considers tax compliance and preparation to be sufficiently tied to the core audit process as to be unlikely to compromise the auditor's independence. Tax compliance and preparation includes the preparation of original and amended tax returns, claims for refunds, and tax payment planning.

While auditors may engage in other types of tax work that are fairly benign, such as tax advice on mergers or benefit plans, these services generally do not feature prominently in the overall dollars paid for tax services. As noted earlier, tax shelter work (formulating tax strategies to minimize a company's tax obligation) is clearly an area of concern, though disclosure identifying it is poor.

Where non-audit (“other”) fees are deemed excessive, shareholders should vote against auditor ratification if it is on the ballot. Similarly, shareholders should withhold votes or vote against audit committee members, since they are responsible for hiring and terminating the audit firm and for approving the services provided. (See "Role of the Audit Committee").

In circumstances where "other" fees include fees related to initial public offerings, bankruptcy emergence, and spin-offs, and the company makes public disclosure of the amount and nature of those fees, which ISS determines to be an exception to the standard "non-audit fee" category, then such fees may be excluded from the non-audit fees considered when determining the ratio of non-audit to audit, audit-related, and tax compliance/preparation fees for purposes of determining whether non-audit fees are excessive.

A similar approach should be taken to shareholder proposals that advocate zero or low tolerance towards non-audit services. These include proposals asking for a total prohibition on all non-audit services or a cap on non-audit fees as a percentage of total fees. [24] Such proposals should be supported where non-audit fees, using ISS's formula, are deemed to be excessive and would prompt a vote against auditor ratification and against the audit committee members.

The Role of the Audit Committee

A focal point of the auditor independence rules promulgated by Sarbanes-Oxley and implemented by the SEC is the critical oversight role played by audit committees. As a key committee, the audit panel is responsible for making certain that a company's financial statements are being properly produced and reviewed by management and the outside accountant. The audit committee can also be utilized to help a company achieve financial stability, security, and success. As characterized by the SEC:

"The final rules recognize the critical role played by audit committees in the financial reporting process and the unique position of audit committees in assuring auditor independence." [25]

A common thread in a number of corporate financial scandals has been insufficient independence among audit committee members. Two of Qwest's audit committee members served at companies that got significant contracts from Qwest. [26] And Enron's six-member audit committee included one director that had a $72,000 annual consulting contract with the company, and two others were employed by universities that received sizable donations from the company. [27]

Early Standards of Independence

The effectiveness of the audit committee can be measured by evaluating its composition and its performance. One of the most important features of an audit committee is its membership, which should be independent of management. This "independence "relates to any real or apparent conflicts of interest, an issue addressed by the SEC 35 years ago. In 1972, the SEC urged registrants to create an audit committee of outside members of the board of directors in order to provide for more effective communication between independent outside directors. It was believed that such a committee would lessen the accountants' direct reliance on management and would put them directly in touch with outside members of the board whose performance was less specifically being reported on in financial statements, thus increasing accountants' independence. [28]

Prior to late 1999, the New York Stock Exchange (NYSE), American Stock Exchange (AMEX), and NASDAQ National Market all required members to have audit committees, though with varying independence standards. Audit committees of NYSE companies had to be composed exclusively of independent members, defined as any non-employee or non-affiliated director. However, under the exchange's definition, the board itself was responsible for determining whether an individual was free from any relationship that would interfere with the exercise of independent judgment as an audit committee member. [29] The NASDAQ National Market also mandated fully independent audit committees, while AMEX only required that they consist of a simple majority of independent outsiders. NASDAQ SmallCap Market companies were not required to have audit committees.

The Blue Ribbon Committee

Accounting abuses in the 1990s led to concerns by former SEC Chairman Arthur Levitt over the deterioration in the quality of financial reporting. In response, the NYSE and National Association of Securities Dealers (NASD) formed the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees (BRC) to investigate how audit committees could improve their oversight of financial reporting. The key recommendations on audit committee independence were adopted as final rules by the SEC and self-regulating organizations (SROs) in December 1999, as follows:

• A more rigorous definition of independence would be applied to audit committee members.
• Audit committees must consist of at least three members who are financially literate and independent (see Table 1).
• At least one member of the audit committee must have accounting or financial management expertise.
• Companies must adopt written charters for their audit committees, and these must be filed every three years.

Both the NYSE and NASDAQ/AMEX made an allowance for one member to be non-independent under exceptional circumstances.

Table 1: Audit Committee Independence (adopted December 1999)

Audit committee member is not independent if: NYSE NASDAQ/AMEX Employee of company If in last 3 years Same as NYSE Employee of parent/predecessor of company If parent/predecessor in last 3 years Same as NYSE Relative of employee Immediate family of executive officer in last 3 years Same as NYSE Compensation committee interlock Executive of a business where a company executive sits on the business' compensation committee Same as NYSE Business relationship with company If a partner, controlling shareholder, or executive officer of a for-profit entity that has a business relationship with the company in last 3 years, then the board determines if material A partner, controlling shareholder, executive officer of a for-profit business where the payment exceeds the greater of $200,000 or 5% of the recipient's revenues in any of last 3 years Gets compensation from company (other than board service) If direct business relationship with the company, then the board determines if material If in excess of $60,000 during previous year

Post-Enron Enhancements

In the wake of Enron, the SROs amended their listing rules to strengthen the definition of independence set out for audit committee members, and extended similar standards to other key board committees. The primary enhancements include:

• In addition to meeting the new director independence criteria (see “Voting on Director Nominees in Uncontested Elections”), audit committee members may not receive any consulting, advisory or other compensatory fees from the company or its subsidiaries other than for board service or retirement plans for prior service. NASDAQ also stipulates that a partner in a law firm that receives payments from the company may not serve on the audit committee. The board will determine the independence of audit committee members who beneficially own ten percent or more of the company’s stock as well as determine if a committee member’s service would be impaired if he simultaneously sits on the audit committees of more than three public companies;
• Audit committees must consist of at least three directors, all of whom must be financially literate and one of whom must have accounting or financial management expertise;
• Audit committees must have a written charter addressing matters such as the committee’s purpose and responsibilities, an annual performance evaluation of the committee, the outside auditor’s accountability to the committee, and the committee’s responsibility to ensure the independence of the auditor;
• NYSE companies must have an internal audit function.
• NASDAQ companies must publicly disclose a “going concern” audit opinion in an SEC filing within seven days of receipt.

These regulations also created a stronger role for the audit committee entailing a direct relationship with the outside audit firm. This represents a departure from the historical relationship between management and the outside auditor, where management retained the accounting firm, negotiated the fees, and contracted for other services. Under the revised SEC rules, the audit committee is responsible for the appointment, compensation, and oversight of the audit firm and for pre-approval of services provided. At the same time, the audit firm is required to communicate critical accounting policies and practices to the audit committee. This provides a forum apart from management where the accountants may discuss their concerns.

Changing the Auditor

In 1992, the American Institute of Certified Public Accountants' (AICPA) SEC Practice Section released its position regarding mandatory rotation of audit firms of publicly held companies. AICPA concluded that there was no credible evidence that rotating audit firms would improve the quality of audits. AICPA explained that a mandatory rotation "would dramatically increase costs for firms, clients and the public. In addition, it would increase the likelihood of poor audits, by depriving auditors of the most valuable tool: experience with a client and the resulting comprehensive knowledge of its business and operations." [30]

The concept of term limits for audit firms was encouraged in a 2002 study by the Conference Board's Commission on Public Trust and Private Enterprise. The Commission advocated rotation if the audit firm has been employed for a substantial amount of time (over ten years); when one or more former partners or managers of the firm are employed by the company; or when significant non-audit services are provided to the company. Apart from building shareholder confidence, the study cited other advantages of rotation:

• The incoming audit firm would be able to take a fresh look at the company's finances, accounting practices and the former firm's audit;
• It would reduce the financial incentives for an auditor to compromise its judgment on borderline accounting issues;
• The audit firm would not be risking a lengthy stream of revenues by disagreeing with management; and
• Knowing its work will be reviewed by another firm would deter questionable judgments by the current audit firm.

While there are costs to companies in changing auditors periodically, the Commission contended that such costs would be significantly less than the market costs resulting from the loss of investor confidence arising from inaccurate financial information.[31]

A 2002 Harvard Business Review study observed that auditors are inclined to have a bias toward the companies that hire them. The authors argue that real independence would require automatic rotation of the audit firm, the prohibition of non-audit services, and a ban on auditors from going to work for their former clients. [32] A number of institutional investors advocate a term limit for audit firms of five to seven years, though some shareholder initiatives have suggested four-year cycles.[33]

Shorter cycles are problematic, however, as the incoming auditor requires a certain period to learn the new business. A GAO study on mandatory audit firm rotation suggested, “that it generally takes two to three years or more to become sufficiently familiar with the companies’ operations and processes before the additional resources often needed to become knowledgeable are no longer needed.” [34] A longer cycle is therefore important to keep costs down and audit quality high.

Audit firms also point to the dearth of audit firms capable of handling the audit for large multi-national companies. With Arthur Andersen’s demise, there are only four top-tier audit firms, making periodic firm rotation difficult. Mandatory rotation may therefore leave little choice for large firms as they are forced to hire a different audit firm but have few real options.

Sarbanes-Oxley has also satisfied some of the needs of those who originally called for mandatory auditor rotation. While legislators did not go so far as mandating audit firm rotation, the Sarbanes-Oxley Act requires switching certain partners on an audit engagement. As stipulated in the final SEC rules, the lead and concurring (reviewing) partners may serve in those roles for five years, then must rotate off for five years.

However, the SEC rules go beyond Sarbanes-Oxley by also mandating that certain other partners be subject to rotation after seven years with a two-year time-out period. This includes partners on the audit engagement team who have responsibility for decision-making on significant auditing, accounting, and reporting matters that affect the financial statements or who maintain regular contact with management and the audit committee. In this manner, the SEC concluded, a balance would be struck between the need to achieve a fresh look at an issuer's financial statements and a need for the audit engagement team to be composed of competent accountants.

ISS continues to believe that rotation of the audit firm would provide a better safeguard against improper accounting than mere rotation of the engagement partners. However, ISS recognizes that Sarbanes-Oxley has lessened the need for auditor rotation and that auditor rotation does raise concerns over both cost and audit quality. ISS is therefore advocating an approach predicated upon the specific operations of the company in question. ISS will examine the firm’s structure, the systematic evaluation of the auditor, and the auditor tenure before making a recommendation on shareholder proposals seeking firm rotation. It therefore recommends a case-by-case approach, taking into account the tenure of the audit firm, the proposed rotation period (e.g., 10 years or more), and whether the company regularly reviews the auditor for both quality and cost.

ISS will also look at the effectiveness of the audit committee; looking at the number of financial experts that serve on the committee, and the number of times the committee met during the year. (A minimum of four to five meetings a year would be indicative of better audit committee oversight.) ISS will examine what process a company has in place to systemically review its auditor and correct any audit-related issues that may arise. An effective review mechanism would lessen the need for auditor rotation.

Factors to Consider When Voting on Auditors

Shareholders must make certain that auditors are responsibly examining the financial statements of a company, that their reports adequately express any legitimate financial concerns, and that the auditor is independent of the company it is serving. When deciding how to vote on the ratification of auditors:

1. Read the auditor's report contained in the annual report, with an eye toward any "red flags" (warnings or concerns) raised by the auditing firm. Any such concerns are noted under discussion of the appropriate ballot item in the ISS proxy analysis.
2. Examine the composition of the audit committee. All audit committee members should be independent outsiders. ISS will recommend voting against any insiders or affiliated outsiders who are committee members.
3. Review whether the company has recently changed its audit firm, and, if so, why the change was made and if there were any material disagreements.
4. Examine the breakdown of fees paid to the company's audit firm for potential conflicts of interest. An excessive portion of non-audit fees may signal that the auditor is conducting other business with the company other than performing the audit and related services.
5. Review any accounting irregularities noted in the annual report or in the press.

ISS is evaluating the issue of limited liability provisions for auditors. Comments from SEC staff indicate that such provisions tend to undermine auditor independence. According to a speech to the 2004 AICP National Conference by the SEC’s senior chief accountant, “when an accountant seeks immunity from liability, such conditions induce departures from objectivity and impartiality; consequently, the account cannot be recognized as independent”

Although SEC comments and available literature indicate that there is concern about auditor independence when limited liability provisions exist, they also suggest that these agreements are prevalent. Note that limited liability provisions typically do not provide for punitive damages. Given the prevalence of such agreements and lack of detailed information on their respective terms, ISS has not changed its policies but will continue to monitor developments in this area.

While conflicts of interest or evidence of egregious accounting behavior would justify voting AGAINST the auditors, shortfalls in any of the other items should be evaluated on a CASE-by-CASE basis.