Crown image Columbia Law School

SEC Addresses Audit Committees’ Role in Financial Reporting

Introduction[1]

The strength of our public company financial reporting system relies on many stakeholders playing different but interconnected roles in a process designed to provide investors and our markets with high-quality, reliable financial information. Audit committees play a vital role in the financial reporting system through their oversight of financial reporting, including the internal control over financial reporting (ICFR) and the external, independent audit process.[2]

In 2002, the Sarbanes-Oxley Act[3] introduced a number of requirements to increase and strengthen the role of audit committees in financial reporting, including the independent audit committee requirement. We believe the measures related to audit committees have proven to be some of the most effective financial reporting enhancements included in the Sarbanes-Oxley Act.[4] Effective oversight by strong, active, knowledgeable and independent audit committees significantly furthers the collective goal of providing high-quality, reliable financial information to investors and our markets.

As the 2019 calendar year-end financial reporting season approaches, we are providing observations and reminders on a number of potential areas of focus for audit committees. Issuers and independent auditors also should be mindful of these considerations with an eye toward ensuring that audit committees have the resources and support they need to fulfill their obligations. To be sure, the scope of an audit committee’s work is broad and includes a variety of important responsibilities, and the observations and reminders noted below are not intended to reflect a comprehensive list of these responsibilities. It is our intention that these observations and reminders will assist audit committees carrying out their year-end work, including promoting efficient and constructive dialogue among audit committees, management and independent auditors in these and other areas.

Observations Regarding Financial Reporting and Auditing

General Observations

  • Tone at the Top – Because audit committees of public companies have financial reporting and independent auditor oversight authority and responsibility, they are instrumental in setting the tone for the company’s financial reporting and the relationship with the independent auditor. We encourage audit committees to focus on the “tone at the top” with the objective of creating and maintaining an environment that supports the integrity of the financial reporting process and the independence of the audit. In this regard, it is important for the audit committee to set an expectation for clear and candid communications to and from the auditor, and likewise to set an expectation with both management and the auditor that the audit committee will engage as reporting and control issues arise. It is similarly important for audit committees to proactively communicate with the independent auditor to understand the audit strategy and status, and ask questions regarding issues identified by the auditor and understand their ultimate resolution.
  • Auditor Independence – Compliance with auditor independence rules is a shared responsibility of the audit firm, the issuer and its audit committee. The audit committee plays a critical role in auditors’ compliance with the auditor independence rules, in part because the Sarbanes-Oxley Act mandates that audit committees be directly responsible for the oversight of the engagement of the company’s independent auditor.[5] We encourage audit committees to consider periodically the sufficiency of the auditor’s and the issuer’s monitoring processes. Among other items, these processes should address corporate changes or other events that could affect auditor independence (e.g., changes or events that may result in new affiliates or business relationships) and facilitate the timely communication of these events and changes to the audit firm.
  • Generally Accepted Accounting Principles (GAAP) – While the process of implementing new GAAP standards is a collaborative effort among different stakeholders, the importance of the audit committee in promoting an environment for management’s successful implementation of new standards cannot be overstated. Particularly in light of the significant new accounting standards recently implemented (e.g., the new revenue[6] and leases[7] standards), we encourage audit committees to engage proactively with management and auditors in the implementation process of new standards to understand management’s implementation plan, including whether the plan provides sufficient time and resources to develop well-reasoned judgments and accounting policies. It is also important for an audit committee to understand management’s processes to establish and monitor controls and procedures over adoption and transition.
  • ICFR – Audit committees are responsible for overseeing ICFR, including in connection with their consideration of management’s assessment of ICFR effectiveness and, when applicable, the auditor’s attestation. We believe audit committees are most effective when they have a detailed understanding of identified ICFR issues and engage proactively to aid in their resolution. If material weaknesses exist, it is important for audit committees to understand and monitor management’s remediation plans and set an appropriate tone that prompt, effective remediation is a high priority.
  • Communications to the Audit Committee from the Independent Auditor – We remind audit committees of the year-end financial reporting process under PCAOB AS 1301, Communications with Audit Committees, which requires the auditor to communicate with the audit committee regarding certain matters related to the conduct of the audit and to obtain certain information from the audit committee relevant to the audit. Among other important items, AS 1301 provides that the auditor should communicate matters related to certain accounting policies and practices, estimates and significant unusual transactions.[8] These requirements are designed to enhance the communications between audit committees and the independent auditor. We encourage audit committees to incorporate this dialogue in carrying out their responsibilities.

More Specific Observations

  • Non-GAAP Measures – Non-GAAP measures and other metrics used to gauge company performance, when used appropriately in combination with GAAP measures, can provide decision-useful information to investors on the company’s performance from management’s perspective. It is important that audit committees understand whether—and how and why—management uses non-GAAP measures and performance metrics, and how those measures are used in addition to GAAP financial statements in the company’s financial reporting and in connection with internal decision making. We encourage audit committees to be actively engaged in the review and presentation of non-GAAP measures and metrics to understand how management uses them to evaluate performance, whether they are consistently prepared and presented from period to period and the company’s related policies and disclosure controls and procedures.
  • Reference Rate Reform (LIBOR) – The expected discontinuation of LIBOR[9] could have a significant impact on financial markets and may present a material risk for many companies. The risks associated with this discontinuation and transition will be exacerbated if the work necessary to effect an orderly transition to an alternative reference rate, a process often referred to as reference rate reform,[10] is not completed in a timely manner. We encourage audit committees to understand management’s plan to identify and address the risks associated with reference rate reform, and specifically, the impact on accounting and financial reporting and any related issues associated with financial products and contracts that reference LIBOR.[11]
  • Critical Audit Matters – Beginning in 2019, certain public companies’ auditors are required to communicate critical audit matters (CAMs) in the auditor’s report.[12] While the independent auditor is solely responsible for writing and communicating CAMs, we encourage audit committees to engage in a substantive dialogue with the auditor regarding the audit and expected CAMs to understand the nature of each CAM, the auditor’s basis for the determination of each CAM and how each CAM is expected to be described in the auditor’s report. In short, we would expect that the discussion of the CAM in the auditor’s report will capture and be consistent with the auditor-audit committee dialogue regarding the relevant matter. We encourage audit committees to continue their efforts to understand the new standard and remain engaged with auditors in the implementation process.

Conclusion

The strength of our capital markets, and the confidence of investors in our markets, is driven by the continued quality and reliability of financial reporting. Independent audit committees perform a vital role in financial reporting and have a significant oversight responsibility in connection with the preparation and review of the financial information our investors and markets expect.

We support and thank audit committee members for their continued efforts to ensure this information is accurate and reliable.

ENDNOTES

[1] This statement represents the views of the Chairman, Chief Accountant and Director of the Division of Corporation Finance of the U.S. Securities and Exchange Commission (“SEC” or “Commission”). It is not a rule, regulation, or statement of the SEC. The Commission has neither approved nor disapproved its content. This statement does not alter or amend applicable law and has no legal force or effect. This statement creates no new or additional obligations for any person.

[2] See, e.g., SEC Chairman Jay Clayton, Statement on SEC Approval of the PCAOB’s New Auditor’s Reporting Standard (October 23, 2017), available at https://www.sec.gov/news/public-statement/clayton-statement-pcaob-new-auditor-reporting-standard, and also SEC Chief Accountant Sagar Teotia, Statement in Connection with the 2019 AICPA Conference on Current SEC and PCAOB Developments (December 9, 2019), available at https://www.sec.gov/news/speech/teotia-speech-2019-aicpa-conference.

[3] Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 (2002).

[4] See, e.g., SEC Chairman Jay Clayton, Statement at Open Meeting on Proposed Amendments to Sarbanes Oxley 404(b) Accelerated Filer Definition (May 9, 2019), available at https://www.sec.gov/news/public-statement/statement-clayton-050919, SEC Chairman Jay Clayton, Statement on SEC Approval of the PCAOB’s New Auditor’s Reporting Standard (October 23, 2017), available at https://www.sec.gov/news/public-statement/clayton-statement-pcaob-new-auditor-reporting-standard and also SEC Chief Accountant Sagar Teotia, Statement in Connection with the 2019 AICPA Conference on Current SEC and PCAOB Developments (December 9, 2019), available at https://www.sec.gov/news/speech/teotia-speech-2019-aicpa-conference.

[5] Section 10A(m) of the Securities Exchange Act of 1934 [15 USC 78j-1(m)].

[6] See FASB Accounting Standards Update (“ASU”) No. 2014-09, Revenue from Contracts with Customers (May 2014), which is codified in Accounting Standards Codification (“ASC”) Topic 606, Revenue from Contracts with Customers.

[7] See FASB ASU No. 2016-02, Leases (February 2016), which is codified in ASC Topic 842, Leases.

[8] See Paragraph .12 of PCAOB AS 1301.

[9] Formerly an acronym for London Interbank Offered Rate, LIBOR is common parlance for its current official name ICE LIBOR. It is expected that a number of private-sector banks currently reporting information used to set LIBOR will stop doing so after 2021 when their current reporting commitment ends, which could either cause LIBOR to stop publication immediately or cause LIBOR’s regulator to determine that its quality has degraded to the degree that it is no longer representative of its underlying market. For further information, see Division of Corporation Finance, Division of Investment Management, Division of Trading and Markets and Office of the Chief Accountant, Staff Statement on LIBOR Transition, (July 12, 2019), available at: https://www.sec.gov/news/public-statement/libor-transition.

[10] See, e.g., FASB, Reference Rate Reform (November 2019), available at https://www.fasb.org/referenceratereform.

[11] See Chairman Jay Clayton, Remarks to the SEC Fixed Income Market Structure Advisory Committee (November 4, 2019), available at https://www.sec.gov/news/public-statement/statement-clayton-fimsac-110419.

[12] See PCAOB AS 3101, The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion.

This statement was issued on December 30, 2019, by Jay Clayton, chairman of the U.S. Securities and Exchange Commission; Sagar Teotia, chief accountant of the SEC; and William Hinman, director of the SEC’s Division of Corporation Finance.