On the hot seat

By Gilles des Roberts
Illustration: Carey Sookocheff

An audit committee seat is not as cozy as it once was. New ironclad rules put pressure on members to understand all the intricate workings of publicly listed firms

For years, a seat on a public company's audit committee was regarded as a sinecure. However in light of the new rules defined and reviewed by the North American financial market regulatory authorities, the age of complacent audit committees has ended. Today committee members have a direct, demanding, strategic and visible role in reporting financial information to investors.

In the US, after the enactment of the Sarbanes-Oxley Act in 2002, which requires that external auditors report to the audit committee of the board that is completely independent of management, the Securities and Exchange Commission (SEC) adopted new rules to meet audit committee requirements as mandated by the act. For example, one rule directed the national securities exchanges and national securities associations to prohibit the listing of any security of an issuer that is not in compliance with the audit committee requirements. These requirements, according to a SEC release, relate to: "the independence of audit committee members; the audit committee's responsibility to select and oversee the issuer's independent accountant; procedures for handling complaints regarding the issuer's accounting practices; the authority of the audit committee to engage advisers; and funding for the independent auditor and any outside advisers engaged by the audit committee."

In Canada, after the Bre-X Minerals Ltd., Cinar and Livent Inc. scandals, steps were taken to remedy market and financial manipulations. Last year, the Canadian Securities Administrators, federal and provincial securities regulators, the Office of the Superintendent of Financial Institutions (OSFI) and the accounting profession set up the Canadian Public Accountability Board (CPAB), which is charged with overseeing the independence and transparency of the Canadian accounting system. According to the OSFI, "The mission of the CPAB is to contribute to public confidence in the integrity of financial reporting of Canadian public companies by promoting high quality, independent auditing. The improved system…means that auditors of Canada's publicly listed companies will undergo more frequent and rigorous inspections, conducted by the independent agency."

The Ontario Securities Commission (OSC), in conjunction with the Canadian Securities Administrators, hopes to be as effective as US regulatory bodies in restoring investor confidence by introducing on January 1, 2004, regulations governing the composition and duties of audit committees, as well as their members' behaviour. The proposed regulations (see "OSC rules" on page 27) will also be adopted by all provincial and territorial securities regulators, except for British Columbia. "The rules are as robust as parallel rules required by the US Sarbanes-Oxley legislation, but address unique Canadian concerns," said OSC chair David Brown in a release announcing the proposed rules.

What makes these proposed regulations unique in Canada is that the federal government is counting on securities regulators, along with a wide range of capital market participants, to see that business uses sound governance practices. "The US has taken the legislative route [with the Sarbanes-Oxley Act]. Corporate governance rules in Canada are currently a mixture of voluntary guidelines and mandatory rules," explained Maurizio Bevilacqua, the Secretary of State (International Financial Institutions), while addressing the Standing Senate Committee on Banking, Trade and Commerce. "Capital markets can, on their own, provide impetus for Canadian public companies to move to the highest standards of corporate conduct," said the Liberal MP for the Vaughan-King-Aurora riding.

And high standards of corporate conduct are a big issue, because, among other things, they help to restore confidence by guaranteeing the independence and effectiveness of audit committees and their members. In a nutshell: good governance equals trust.

"A climate of trust is part of society's social capital. In the wake of the financial scandals, rebuilding values is just as important as amending regulations. And it's especially important for companies whose operations are wholly based on trust, such as public accountancy firms," says Marcel Boyer, economics professor at Université de Montréal, speaking at the World Economic Forum in Davos, Switzerland. "Don't forget that in just a few weeks, the Enron scandal annihilated Arthur Andersen, at that time the largest public accountancy firm in the world."

By setting clear and incontrovertible rules for audit committees, John Carchrae, OSC chief accountant, sees the proposed regulations boosting investor confidence. "Basically it means putting appropriate people in place and making them assume clearly defined responsibilities," he says. "The proposed regulations aim to achieve this by strengthening the audit committee over-sight structure. It was developed in line with the one already implemented by the SEC and the US exchanges."

But it's not just the regulatory authorities that are applying pressure to change the composition of audit committees. Institutional shareholders are also mounting the barricades and demanding greater effectiveness on the part of boards and their committees. In Canada, audit committee competence and integrity is a war-horse of the Canadian Coalition for Good Governance. This investors' coalition, with $350 billion invested in Canadian publicly traded companies, has empowered itself to assess and comment on the qualifications of audit committee members.

The basic principle of the new regulations boils down to the fact that the audit committee's mandate is directly tied to the ultimate role of any board of directors — senior management is accountable to the board of directors, which in turn is accountable to shareholders. From this perspective, and in a business climate where the slightest hint of accounting or financial scandal causes a flood of market, legal and regulatory problems, the responsibilities of audit committee members are tremendous.

The OSC's draft regulations regarding audit committee composition usher in two major changes. The audit committee will now be required to have a charter and a mandate to document new current and future procedures, such as the concept of whistle-blowing, which plays a prominent part in the new governance principles, explains Jim Goodfellow, senior partner at Deloitte & Touche in Toronto. The other major change has to do with the qualifications of audit committee members.

"Basically, we must ensure that independent and qualified people sit on the audit committee," Goodfellow says. However, the OSC's regulation is discreet in some respects. "It has little to say about the information the audit committee must report on its activities. It is also silent on the subject of how to manage the new relationship between management, the board of directors, other committees and external auditors.

OSC Rules As part of its campaign to restore investor confidence in the capital markets, on January 1, 2004, the Ontario Securities Commission, in conjunction with the Canadian Securities Administrators, will introduce regulations to be adopted by all provincial and territorial securities regulators, except for British Columbia, and while they parallel the US Sarbanes-Oxley legislation, they address three unique Canadian concerns: CEO and CFO certification of annual and interim disclosures: CEOs and CFOs of all Canadian public companies will have to personally certify four times a year that their issuers' annual and interim filings do not contain a misrepresentation and that they fairly present the issuers' financial condition. They will also have to certify they have reasonable internal controls in place. The role and composition of audit committees: It addresses the conflict of interest that may arise when management assumes the role of overseeing the relationship between an issuer and its external auditors. Every reporting issuer must have an independent audit committee to which the external auditors must directly report. Every audit committee must have a least three members, each independent and financially literate. Support for the work of the Canadian Public Accountability Board in its oversight of auditors of public companies: Public accounting firms that audit the financial statements of reporting issuers must participate in the public oversight program established by CPAB and remain in good standing with CPAB. Public accounting firms must provide notice to securities regulators in situations where restrictions or sanctions are imposed following a CPAB inspection.

"An effective audit committee must be able to communicate well with all its partners in order to compile information needed for decision-making. Like other duties arising from the new regulations, this new duty, which is essential to sound governance, puts a lot of pressure on the committee chair's shoulders. This is the person who has to steer any initiatives, which increases his or her visibility and requires him or her to use diplomacy with out undermining the CEO's authority and responsibilities."

Pierre Brunet, corporate director, former chair and CEO of National Bank Financial and CICA chair, has some reservations about the audit committee regulations. "It's a mistake to see governance as the preserve of the audit committee. A board has many committees that should all have a hand in governance. And all of them should be on an equal footing."

Brunet adds, "The new rules need to reflect a Canadian market because in many cases we're dealing with a much smaller scale in company size. In Canada, 4,600 companies are listed on the various stock exchanges, but 2,000 of them have a market capitalization of less than $10 million."

For some companies, the costs associated with implementing the proposed requirements can be a greater burden. According to an OSC cost/benefit analysis conducted in June, it will cost an estimated $43 million to $165 million over 10 years to hire and support additional independent directors for TSX firms. But the OSC estimates that over the same period, through the impact of reduced earnings smoothing and other manipulations, the benefits will be in the range of $1 billion to $9.2 billion or 0.04% to 0.4% of total assets. What's promising, however, is that out of a sample of 306 TSX-listed companies, 154 already meet the independent audit committee criteria. Another 102 companies could fulfill the requirements by replacing inside directors on the audit committee with independent directors already on the board.

Under the new rules, the OSC is also introducing the concept of "financial literacy," whereby every audit committee member will be required to be financially literate. OSC's Brown defines it as, "the ability to read and understand a set of financial statements that present a breadth and level of complexity of accounting issues comparable to those that can reasonably be expected to be raised by the issuer's financial statements."

In addition to being qualified and financially literate, audit committee members must have time to discharge their duty and, above all, be independent. Moreover, audit committees are required to have a financial expert — one who understands financial statements and the accounting principles used to prepare financial statements among other requirements — serving on the audit committee. If audit committees don't have a financial expert, they'll need to disclose it and explain why they don't have one.

"The OSC's draft rules considerably increase the audit committee's level of responsibility and bring them into substantial congruity with the US requirements," says Tom O'Neill, former CEO of PricewaterhouseCoopers (Canada) and chairman of BCE Inc.'s audit committee. "From now on, members must understand the key components of a company, not only its financial data but also its organization and markets — the business operations and how they are reflected in the financial statements. This is a huge challenge for boards of a highly complex company like a Canadian bank."

Some believe that the higher expectations placed on the audit committee are sure to lead to changes in the behaviour and practices of members. "I am convinced the new rules will complicate audit committee recruitment, an already complex thing to which a new level of competence and responsibility will be added, the so-called 'financial expertise,' " says O'Neill. Even worse, he believes candidates may refuse invitations to sit on audit committees because they may feel unqualified. Plus, committee members, especially the chair, could see their workload increase.

However, for new and future audit committee vacancies, Goodfellow is convinced that Canadian companies will have to go outside the traditional recruitment pool to fill future audit committee vacancies. "Right now, audit committees consist mainly of retired CEOs. But corporate management should remember there are 68,000 chartered accountants in Canada who currently meet the OSC's financial literacy and expertise criteria and could be available if they enhanced their corporate governance knowledge and skills," says the accountant who, with Maureen Sabia, wrote Integrity in the Spotlight: Opportunities for Audit Committees (2002).

According to Sabia, who is a lawyer and corporate director, the new rules for audit committees proposed by the OSC "have merit and will provide a foundation for improvement, but they can't do the job alone." She explains that audit committees evolve in three stages. Stage one is the dependent stage, where "the committee and external auditors were totally dependent on management." Most audit committees have already achieved stage two — the independent stage. Here, initiatives by the TSX and other regulators during the early 1990s encouraged parties to operate independently. However, Sabia advocates that audit committees move to the final stage — "a stage in which the parties all work together to achieve their common objective, the integrity of financial information, accountability and transparency," says Sabia, who has served on audit committees since 1986 and currently chairs Canadian Tire's audit committee.

"Achieving independence alone does not guarantee the effectiveness of either the audit committee or the external auditor," she says. "That occurs only when the audit committee, the external auditor and management recognize the interdependence of the relationship among them.

"The effectiveness of all three parties will only be achieved fully when they put into place channels of communication that permit all three to inform each other of matters of concern and discuss them candidly; develop trust in and respect for each other's motives and goals; and generate positive interaction among themselves."

Gilles des Roberts is a Montreal-based writer. Fina Scroppo, a Toronto writer and editor, contributed to this article.