Corporate Audits Need Greater Independence

Robert Carlson
Senior Member, CalPERS Board of Administration
Chair, Finance Committee

As a shareholder in over 1,600 U.S. companies, the California Public Employees' Retirement System ("CalPERS") has a strong interest in the integrity of corporate financial reporting. Unfortunately, today there are serious questions about whether our reporting system is as strong as we may once have thought. We are experiencing a phenomenal bull market, with increasing focus placed on corporate earnings. At the same time, companies are relying more on corporate restructurings to address ever-changing business trends, and on increasingly complex financial instruments to manage risks. SEC Chairman Arthur Levitt, Jr., at a recent address at NY University, expressed his "fear [that] we are witnessing a gradual, but noticeable erosion in the quality of financial reporting," and the emergence of a "grey area . . . where accounting practices are perverted; where managers cut corners; where earnings reports reflect the desires of management rather thant he underlying financial performance of the company."

The need for a strong and transparent corporate financial reporting system is obvious. The very integrity of the securities markets rests on the integrity of this reporting. Many reports on this topic have been produced over the past several years; few have resulted in tangible change. In February of this year, however, a report was issued that could - and should - fundamentally change this pattern. The Blue Ribbon Committee's Report on Improving the Effectiveness of Corporate Audit Committees ("Blue Ribbon Report") offers recommendations that are both thoughtful and practical. CalPERS encourages all US companies in which we invest to support the Report's recommendations and goals, most principally:

1. The key to effective financial reporting oversight is the competency, strength and independence of the audit committee.

   During the past decade, the role and importance of the independent director has been the centerpiece of the global discourse on corporate governance. At its core, "good" corporate governance simply means that structures and processes are in place to ensure that directors have the ability to objectively and effectively assess management and corporate performance. When this general standard is applied to financial reporting, it is clear that the audit committee is the key to fulfilling the board's oversight function.

   CalPERS recognizes that "independence" is more a feature of one's character and spirit than the creature of a definition. Nonetheless, we have long been frustrated with the seemingly endless degree of discretion that the current exchange listing standards grant boards of directors to determine whether a member of an audit committee is "independent." The recommended revisions to these standards, for companies with a market capitalization above $200 million, are appropriate limitations to this discretion. This is particularly true since the proposed revision also grants companies, under exceptional and limited circumstances and where it is required by the best interests of the company and its shareholders, the ability to name an otherwise "non-independent" director to the audit committee.

   As important as independence is, it alone cannot guarantee quality financial reporting. CalPERS strongly supports the Report's recommendation that (again, for large sized companies) (a) at least three members of an audit committee be "financially literate" (or become so within a reasonable period of time), and (b) at least one member of the committee have accounting expertise. This recommendation will go far to improve the ability of audit committees to perform their job.

2. Focus should be more on the quality of financial reporting, and not simply the acceptability.

   The Report is clearly seeking to raise the floor - for audit committees, for outside auditors, and for corporate management (including the internal auditor). As the Report correctly points out, the current state of dialogue between outside auditors and the audit committee has the danger of becoming "rote" and "form." Focusing discussions only on what is "acceptable," in terms of accounting standards, deprives the audit committee of the full benefit of the outside auditor's expertise.

   But, as the Report notes, many different disciplines and organizations - the SEC, NYSE, NASD, GAAS and the ISB - must all cooperatively work together to refocus attention on "quality." CalPERS joins the Blue Ribbon Committee in recommending that:

   • GAAS require outside auditors to discuss with audit committees questions of quality (including the auditors' observations regarding clarity of disclosures, degree of aggressiveness or conservatism of principles and estimates).
     
     
   • The SEC require enhanced annual disclosure of the quality of discussions between the members of the audit committee, and between the audit committee and both internal management and the outside auditor.
     
     
   • The NYSE and NASD require, as part of every listed companies' audit committee charter, that the audit committee consciously consider the independence of its outside auditor, including actively discussing with the auditor the other business relationships that the auditor has with the company and company management.

As an attorney, I recognize that some may claim that, by increasing the disclosure of audit committee discussions and considerations, audit committee members will be exposed to increased risk of class action and derivative lawsuits and potential liability. While the potential for frivolous lawsuits is always a concern, CalPERS does not believe that the recommended revisions will increase liability. Among the Report's recommendations is that the SEC create a "safe harbor" applicable to the annual audit committee disclosures, as well as the decisions made by the committee members. This will avoid any question of liability under federal law. Moreover, the common law has never imposed upon directors and audit committees the obligation that they always make the "right" decision; the law only requires that they follow a reasonably prudent and independently minded decision-making process. The Report's recommendations provide greater detail as to what an appropriate process should entail, thus eliminating much ambiguity as to what current standards are. It is likely that that the courts will look to the Report's recommendations when evaluating the quality and independence of audit committee processes. To the extent a committee follows the recommended course, no additional liability should result.

The Blue Ribbon Committee's Report deserves broad and universal support. CalPERS joins the many other firms, organizations and distinguished experts that have gone on record in support.