SEC Considering Possible Revisions to Audit Committee Disclosure Requirements
Monday, July 27, 2015

The Securities and Exchange Commission (SEC) recently issued its long-promised concept release (Release) seeking comment on possible revisions to disclosure requirements regarding audit committees of boards of directors, especially as to audit committees’ oversight of independent auditors and their performance of audits. Concept releases can be harbingers of new rulemaking, as was the case with respect to a September 2004 concept release that preceded the adoption of the XBRL disclosure rules. Comments on the possible revisions to disclosure requirements discussed in the Release, which could influence future SEC rulemaking, are due by September 8, 2015.

Impetus for the Release

For years, members of the investment community have been calling for enhanced audit committee disclosures. For example, in November 2013, a group calling itself the “Audit Committee Collaboration,” which included the National Association of Corporate Directors and the Center for Audit Quality, issued a report titled “Enhancing the Audit Committee Report: A Call to Action.” That report encouraged public company audit committees “to thoughtfully reassess their reporting and communication with stakeholders and, if need be, to strengthen them in the future.” In addition, the compliance and corporate governance media have continued to discuss the possibility of expanded audit committee disclosure requirements. Some issuers have responded to the calls for more disclosure by voluntarily including enhanced audit committee disclosures in their proxy statements. Moreover, the Public Company Accounting Oversight Board (PCAOB) has been considering proposals to mandate additional disclosures in audit reports and elsewhere, including the identification of the engagement partner on each audit in the audit report.

Against this background, the SEC issued the Release. In the Release, the SEC points to numerous benefits that could accrue to investors from enhanced audit committee disclosures, not the least of which, it believes, would be a narrowing of the “expectations gap” between investors and audit committees regarding the role of the audit committee. 

Potential New and Revised Audit Committee Disclosure Requirements

The SEC states the purpose of the potential new disclosure requirements is “to address the audit committee’s responsibilities with respect to the appointment, compensation, retention, and oversight of the work of the registered public accounting firm and [to] better inform investors about how the audit committee executes those responsibilities.” The most important of the potential new disclosure requirements (Potential Disclosure Requirements) are lumped into the three somewhat overlapping categories summarized below. In addition to seeking comments on the following categories, the SEC has requested comments on other, less significant matters, including the proper location of audit committee disclosure in SEC filings.

Audit committee’s oversight of the auditor. This category includes potential disclosures relating to:

  • how the audit committee assesses, promotes and reinforces the auditor’s objectivity and professional skepticism, which are areas of increased focus among numerous groups concerned with audit quality;

  • communications between the audit committee and the auditor, including disclosure relating to the nature of communications and the subjects discussed, among which could be overall audit strategy, significant risks identified, the basis for determining that the auditor could act as principal auditor and the results of the audit;

  • whether and how the audit committee considered all the matters addressed in those communications, including how the auditor planned and performed the most recent audit; and

  • details about the audit committee/auditor communications, including matters such as the frequency, nature and forums of such communications.

The SEC claims that heightened audit committee oversight of auditor objectivity and professional skepticism should promote improved audit quality. If so, the onus of ensuring auditor objectivity and skepticism would be squarely on the audit committee even though reinforcement of the objectivity and skepticism of audit firm personnel is seemingly a matter more inherently within the responsibility of the audit firms and the PCAOB. Boards of directors and audit committees should be concerned that the Potential Disclosure Requirement regarding this matter could raise investor expectations that audit committees will be guarantors of auditor objectivity and skepticism, placing the committee members in the cross-hairs of irate investors if an audit failure occurs as a result of a perceived lack of auditor objectivity or professional skepticism.

Moreover, some of the Potential Disclosure Requirements described above appear to be based on an assumption that audit committees delve deeply into the specifics of the planning and conduct of each particular audit.

The Potential Disclosure Requirements in this category also include potential disclosures regarding:

  • the audit committee’s review and assessment of information such as reports prepared by the audit firm regarding certain matters and PCAOB inspection reports and discussions of those reports with the auditor;

  • how the audit committee considered deficiencies identified in the PCAOB inspection reports; and

  • the nature of the audit committee’s review of such materials and whether it discussed those matters with the audit firm.

The SEC has also requested comments on whether disclosures regarding the review of such materials by the audit committee and the audit committee/auditor discussions would be useful without disclosure of the specific review and inspection results. In this regard, the SEC must proceed with care as the prospect of the disclosure of such matters has, as the SEC recognizes, the potential for chilling communications between audit committees and auditors.

Audit committee’s process for appointing or retaining the auditor. This category includes potential disclosures relating to:

  • the process and the criteria, including indicia of audit quality, used by the audit committee to assess audit firms, including those firms’ independence and objectivity;

  • the audit committee's rationale for selecting a new auditor or retaining an existing auditor;

  • the audit committee's assessment of audit quality and the means and metrics used to assess the quality of an audit of an issuer’s financial statements;

  • the audit committee’s involvement in setting auditor compensation;

  • whether and how the audit committee makes requests for proposals (RFP) from audit firms to perform independent audits and the details of any RFP process; and

  • the board of director’s policy regarding having an annual shareholder vote to approve or ratify the auditor selection and the audit committee’s consideration of any voting results in its auditor selection process.

These disclosures could result in scrutiny of an audit committee’s vetting of audit firms in connection with the engagement or retention of an auditor, the process and criteria the committee uses for auditor selection and how well an audit committee evaluates an audit. Such scrutiny would most likely occur when an issuer’s audited financial statements have been the subject to an audit failure and the auditor had prior audit failures.

Qualifications of the audit firm and certain members of the engagement team selected by the audit committee. This category includes potential disclosures of or relating to:

  • the factors the audit committee considered most relevant in selecting or retaining any auditor and information about the auditor that will perform the issuer’s next audit;

  • the engagement partner’s name and, perhaps, the names of other key members of the audit team;

  • the experience the auditor and those individuals brings to the audit;

  • whether the audit committee was involved in the selection of the audit engagement partner and what it considers in providing input on that selection; and

  • the number of years an existing auditor has been engaged by the issuer.

The qualifications and independence of an audit firm and the audit team’s members are core matters for consideration in an audit committee’s selection of an auditor. The Potential Disclosure Requirements described above are based on a belief that audit committees are well positioned to, and must be able to, evaluate effectively the independence and qualifications of audit firms and the engagement and review partners and other personnel that may be on the audit. How the audit committee assesses those matters in its selection of an auditor could ultimately be the subject of expanded audit committee-related disclosure.

Concerns with Expanded Audit Committee Disclosure

The advocates of expanded audit committee disclosure may believe that the salutary effects of greater transparency regarding audit committees and their activities relating to auditors can be attained without significant cost to issuers and will be an unalloyed benefit to the investment community. In truth, that transparency may come at a very real, and possibly a high, cost—a greater reluctance on the part of highly qualified individuals to serve on audit committees. Certainly no one doubts that audit committees play, and should play, an important role in corporate governance and oversight. In our experience, audit committee members take their responsibilities in that role very seriously and are conscientious in discharging those responsibilities. A decision to serve on such a committee already is a difficult one. That decision may well be even more difficult for highly-qualified prospects as they consider the potential exposure and additional demands on their time that would follow in the wake of mandated additional disclosure and related expansion of their roles.

The SEC’s view that the expectations gap will be narrowed by the disclosures that result from the mandate of the Potential Disclosure Requirements is, in our view, most likely unrealistic. The expanded disclosures are more likely to provide shareholder activists with a more advantageous starting point for their next round of demands for more extensive disclosure regarding audit committees and their actions. Even if overwhelming evidence exists that the costs of the additional requirements outweigh any real benefit to be gained, issuers and audit committees will likely find enhanced disclosure in their futures.

 

NLR Logo

We collaborate with the world's leading lawyers to deliver news tailored for you. Sign Up to receive our free e-Newsbulletins

 

Sign Up for e-NewsBulletins