On December 15, 1999, the Securities and Exchange Commission ("SEC") adopted new rules regarding audit committee disclosures and auditor's review of quarterly financial statements in order "to promote investor confidence in the securities markets by improving the transparency of the role of corporate audit committees and enhancing the reliability and credibility of financial statements of public companies." This bulletin provides a brief overview of the new rules and amendments.

Audit Committee Report in Annual Proxy Statement

New SEC rules dealing with the role of audit committees in financial reporting must be complied with after December 15, 2000. One group of changes include new Item 306 of Regulations S-K and S-B and new Item 7(e)(3) of Schedule 14A, the proxy regulations. These new rules require a company to included in its proxy statement relating to an annual or special stockholders' meeting at which directors are to be elected, or in any solicitation materials for the election of directors by means of a consent solicitation process, a report by the company's audit committee, or its board committee tasked with similar responsibilities or its board of directors (if there is no special committee in place), similar to the report currently required from a company's compensation committee. Item 306 specifically requires the audit committee to state:

  • whether the audit committee has reviewed and discussed the audited financial statements with management;
  • whether the audit committee has discussed with the independent auditors the matters required to be discussed by SAS 61, as may be modified or supplemented;
  • whether the audit committee has received the written disclosures and the letter from the independent auditors required by ISB Standard No. 1, as may be modified or supplemented, and has discussed with the auditors the auditors' independence; and
  • that, based on the review and discussions referred to above, the audit committee has recommended to the Board of Directors that the company's audited financial statements be included in the company's Annual Report on Form 10-K or 10-KSB.

Item 306 further requires the names of the members of the audit committee to appear below the disclosure. This requirement along with the others listed above emphasize the SEC's belief that Item 306 will provide investors with a better understanding of the audit committee's oversight role in the financial reporting process and more confidence in the reliability of a company's financial disclosures.

Audit Committee Charter

While the SEC does not mandate that audit committees adopt charters, the NYSE, AMEX and Nasdaq all require that audit committees adopt charters by June 14, 2000. The charters must specify the following:

  • the scope of the committee's responsibility;
  • the accountability of the outside auditor to the board of directors or audit committee;
  • the responsibility for selection, evaluation and replacement of the outside auditor; and
  • responsibility for overseeing the independence of the auditor.

Once a company has adopted an audit committee charter, new Item 7(e)(3) of Schedule 14A now requires that a copy of the charter be included as an appendix to a company's proxy statement relating to meetings of stockholders held after December 15, 2000, at least once every three years. The SEC feels that this disclosure requirement will aid in the shareholders' assessment of the role of and responsibilities of the audit committee.

Disclosures Concerning Independence of Audit Committee Members

According to the SEC, it is important that companies have audit committees that are comprised principally of independent directors and that a company describe the "independence" of such committee members to its stockholders. Therefore, the SEC adopted a new Item 7(3) to Schedule 14A to require companies, including small business issuers, to disclose in all proxy statements relating to meetings of stockholders held after December 15, 2000, whether or not its audit committee members meet the independence definitions made applicable by the principal stock exchange on which the company's securities are listed (NYSE, AMEX or Nasdaq). For companies whose shares on not listed on any exchange or on Nasdaq, they are required to choose one of the exchange's independence definitions and disclose whether or not the audit committee members meet that test. In addition, effective December 14, 1999, the definitions of independence adopted by each exchange and Nasdaq have been amended. The NYSE enumerates three types of individuals who may not be independent directors. Similarly, the AMEX and Nasdaq list five categories of individuals who are not considered independent directors. The definitions are explained in more detail in SEC Release Nos. 34-42231, 34-42232, and 34-42233.

It is important to note that the listing standards of the NYSE, AMEX and NASD state that companies also may appoint at least one director to the audit committee who is not independent. However, if it does so, a company must disclose the nature of the relationship that makes the individual not independent and the reasons for the Board's determination to appoint such a person to the audit committee.

Some commentators expressed concern that the amendments regarding disclosure of audit committee members' independence would subject a company to increased liability. In response, the SEC provided in Items 7(e) that these new disclosures would not be considered "soliciting material" that is "filed" with the Commission and subject to Regulation 14A or 14C. Therefore, these disclosures will not subject to the antifraud provisions of Rules 14a-9 or 14c-6 or to the liabilities of Section 18 of the Securities Exchange Act of 1934, except to the extent that the company specifically requests that it be treated as soliciting material, or specifically incorporates it by reference into a document filed under the Securities Act of 1933 or the Securities Exchange Act of 1934.

Review of Quarterly Financial Statements

The SEC amended Rule 10-01(d) of Regulations S-X and Item 310(b) of Regulations S-B to require that a company's independent auditors review the interim financial statements included in quarterly reports on Form 10-Q or 10-QSB. The reviews must be provided for all quarterly reports filed for quarters ending on or after March 15, 2000. The auditors must follow professional standards and procedures for conducting such review, as established by generally accepted auditing standards. According to the SEC, this amendment is intended to have a positive effect on the financial reporting process because auditors will be involved earlier in the year, thus reducing the likelihood of restatements or other year-end adjustments. Additionally, inappropriate earnings management may be deterred by imposing more discipline on the process of preparing interim financial information before filing it with the SEC.

Supplemental Quarterly Data in Annual Report on Form 10-K or 10-KSB

In conjunction with the new requirements for interim reviews, the SEC has now extended the requirements of Item 302(a) of Regulation S-K to all companies that have securities registered under Section 12(b) or 12(g) of the Securities Exchange Act of 1934, other than foreign private issuers. This will require disclosure of selected quarterly financial data in a company's Annual Report on Form 10-K or 10-KSB for all fiscal years ending on or after December 15, 2000. Previously, only large widely-held companies were required to supplement their annual financial information with disclosures of selected quarterly financial data. Despite the objection of some commentators that this reporting requirement will cause small companies to incur greater costs, the SEC believes the supplementary financial information is justifiable as a useful resource for investors. Overall, the SEC believes that all of the new interim financial review and disclosure requirements will improve the quality of accounting estimates, communications between clients and auditors and price efficiency of the issuer's securities without imposing significant costs or delays in filing.

The final rules and amendments regarding audit committee disclosure are explained more fully in SEC Release No. 34-42266. All SEC Releases may be accessed from the SEC's website at www.sec.gov.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

FOR FURTHER INFORMATION, CONTACT Paul R. Rentenbach or Liza B. Larky.