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Pozen on Making Audit Committees More Effective

In a post on Harvard Law School's Forum on Corporate Governance and Financial Regulation, Robert Pozen,  Chairman of MFS Investment Management and a Senior Lecturer of Business Administration at Harvard Business School, provides his thoughts on how corporate board audit committes can be more effective.  Pozen asserts that during the recent financial crisis, many audit committees of large financial institutions and financial services firms were caught off-guard by the magnitude of the risks engaged in by their companies.  Though these audit committees maintained proper independence, complied with all the laws and regulations required, properly oversaw their audit relationships, and complied with disclosure and filing requirements, their companies' off-balance sheet liabilities and associated risks came as a surprise.  

Pozen offers three pieces of advice to audit committees to help them prevent the kind of blind spots identified by the financial crisis.  

First, the auditors should highlight any set of transactions — such as sales or borrowings as well as tax-motivated deals — which occur repeatedly at the end of quarters or financial years. It is quite reasonable to design one complex transaction in response to a unique set of circumstances; it is more suspicious if similar transactions occur frequently near the end of a reporting period.

Second, the auditors should identify any material item where the accounting literature allows alternative methods of presentation and explain why the company believes its alternative is preferred. For example, the accounting literature allows, but not does not require, companies to use hedge accounting in certain circumstances. Committee members should be fully briefed on whether and why the company decided to use hedge accounting.

Third, and perhaps most importantly, the auditors each year should provide the audit committee with any material differences in significant accounting policies between the company and its four or five main competitors. This comparative analysis should cover polices such as revenue recognition, warranty obligations, retirement plan obligations, tax reserves, and valuation of goodwill or other intangibles. Some of the differences in accounting treatment will be due to differences in how the companies run their businesses; others will represent accounting judgments that the committee should fully understand.

Though following these suggestions will not guarantee audit committees will detect or prevent fraud or other malfeasance, incorporating these practices into the committee's considerations will help audit committees identify the key judgments made by management and the external auditors in preparing the company's financial statements.  Asking questions about and having a complete understanding of the estimates and more judgmental areas of the financial statements may help audit committees avoid blind spots and the kinds of nasty surprises they conceal.  

The full text of Pozen's article is available at:  http://blogs.law.harvard.edu/corpgov/2011/03/03/what-audit-committees-dont-know/