The article correctly identifies several factors. The SEC did delay issuing final rules on the CEO pay ratio until the second half of 2012, effectively postponing corporate disclosure of the ratio of chief executive pay to the company’s median salary until the 2013 proxy season. Also, a substantial number of comment letters have already been submitted to the SEC on matters regarding executive compensation disclosures, including some for which there are no rules pending. Lastly, the rules mandated for pay ratios in Dodd-Frank are unlike most other provisions in the legislation, in that Congress did not allow for much flexibility in crafting the final rules.

However, the NYT editorial did not mention several factors that have hindered progress for the SEC. According to the May 2012 Dodd-Frank Progress Report from Davis Polk, of the SEC’s 95 required rulemakings, the agency has missed the deadline for 56. When final rules are actually released, they are often met with criticism and lawsuits. Last summer the U.S. District Court of Appeals overturned the SEC’s proxy access rule on the basis that the agency had not conducted a thorough cost-benefit analysis. The SEC subsequently introduced a more robust economic analysis in its rulemaking process, leading to a missed deadline for releasing a final rule regarding the conflict minerals provision—which will require companies to track and disclose their use of minerals potentially sourced from the Democratic Republic of the Congo.

With the rigid mandates on the pay-ratio disclosure, the SEC is facing difficulties with one area not clearly defined: computing median compensation. While Dodd-Frank was explicit in the calculation of the ratio, it was not clear in how the median total compensation would be measured. This measurement leads to several questions: Does the compensation of every employee at an organization need to be computed? Should part-time employees be included in the calculation? Would international employees be included? If so, what foreign exchange rate would be used? Taking these questions into consideration, last August the AFL-CIO proposed the use of statistical sampling to calculate the median compensation, an option the SEC is taking seriously.

The argument is no longer whether pay ratio disclosures will have the intended effect of changing executive compensation. Instead, it is when and how these rules will be issued.

FirstMerit stated that the company’s “compensation policies and procedures…are imperative to align the compensation of the company’s named executive officers with [its] business goals and long-term success and that such compensation and incentives are designed to attract, retain and motivate the Company’s key executives.” This statement is identical to the one made in their proxy last year, which received majority shareholder support.

An article in the Wall Street Journal indicated that FirstMerit awarded $6.4 million in total compensation to its CEO in 2011, although its stock trended downward from early 2010 to late 2011. Last year, several companies that lost a say-on-pay vote also faced complaints of a pay for performance disconnect. For example, Jacobs Engineering raised executive compensation nearly 34 percent despite its one- and three-year shareholder returns being below the median of its peer group.

In response to a failed advisory vote, Jacobs Engineering chose to engage directly with shareholders and discuss the rationale for its compensation policies. In 2012, the effort paid off and Jacobs received majority support for its pay plans.

Beazer Homes also approached shareholders after they rejected the 2011 say-on-pay vote. According to the company’s 2012 proxy statement, the compensation committee directed management to “contact several major stockholders in order to better understand the reasons behind the [say-on-pay] vote outcome.” Additionally, the proxy lists the significant changes made to the compensation plan. In February 2012, Beazer Homes reported that the shareholders had overwhelmingly approved the revised compensation plan.

Failing a say-on-pay vote presents a challenge for boards. In some cases, shareholder outreach can provide valuable insights into investor concerns. Over the past year, Jacobs Engineering, Beazer Homes, and others have proved that this type of engagement can succeed.

Surveying directors on their confidence in the first quarter of 2012, the overall BCI score rose nearly six points to 60.6. Although an improvement over its Q3 2011 low of 47.5, the BCI is yet to reach its peak—achieved in Q1 2011—of 64.9. This growth is achieved through a consistently improved outlook for the long-term future of the economy, as well as progress made in the past year. Directors tend to be less confident in short-term economic conditions.

The boardroom is not unfounded in its hesitancy to predict the state of the economy in the coming months. The JOBS Act was recently signed into law, the future of the health care reform legislation is under debate, and most companies are in the midst of proxy season. Not to mention the list of proposed and final rules expected to come from the Securities and Exchange Commission and Public Company Accounting Oversight Board.

Thirty-six percent of directors responded that their company’s hiring practices resulted in a net gain in the last quarter. This is a 5 percent increase over Q4 2011. However, the amount of directors who plan to expand their workforce in the next quarter declined by nearly 15 percent.

Produced in conjunction with Pearl Meyer & Partners, this quarter the BCI introduced two questions that will provide significant benchmarks in the coming months. When asked if their CEO is on track to meet incentive plan performance objectives for this fiscal year, 74 percent of directors said their CEO was on schedule. Twenty-two percent noted their CEO was behind schedule. Furthermore, 60 percent of directors are confident their CEO will meet these incentive plan goals.

To read more about the BCI, click here.

The prevalence of independent lead directors has increased in recent years. According to the 2011 NACD Public Company Governance Survey, 65 percent of public companies have an independent lead director, which is the highest rate since NACD began surveying the director community on this question in 1995. Additionally, 88 percent of companies with lead directors said that the position enhanced the board’s effectiveness.

Increased boardroom independence has been in the spotlight recently—for investors and legislators. In 2011, there were 24 shareholder proposals for establishing an independent board chairman (data collected from Jan. 1, 2011 to Jun. 21, 2011). Additionally, shareholders offered up 39 proposals in both 2010 and 2009. In 2010, the Dodd-Frank Act implemented a mandate requiring companies to disclose the rationale behind their current leadership structure—whether the chairman/CEO positions are combined or separated.  

The role of the independent lead director has also grown in importance. In 2011, the Report of the NACD Blue Ribbon Commission on the Effective Lead Director found that “the lead director has the ability to give the board a competitive advantage.” The Blue Ribbon Commission identified several areas enhanced by lead directors, including: identifying emerging issues and ensuring they are addressed; maximizing board effectiveness; fostering complete board discussion; and providing leadership in times of crisis.

Regardless of leadership structure, an independent voice leading the work of the board enhances any company. Goldman Chairman and CEO Lloyd Blankfein echoed this sentiment, stating, “I know our people and our shareholders will benefit greatly from [Schiro’s] deep experience in his new role on our board.”

Yes, I hated math. (Making 8s look like snowmen didn’t fool me; this was work!) Today, for myriad reasons I have grown to love math. But I can’t say that I love accounting and auditing (A&A). Now, I’m not angry enough at A&A to burn ledgers, but I do have a complaint: A&A today involves not only jolly numbers—but ever-changing ones, along with ever-multiplying acronyms. This can make serving on not only the audit committee, but also the board of directors, extremely challenging.

As we all know, all audit committee members serving on the boards of companies listed on the New York Stock Exchange (NYSE) or NASDAQ must be (or become) financially literate. The NYSE leaves the definition of literacy up to the board. NASDAQ, however, has defined this as the ability to read and understand fundamental financial statements. At NACD, we believe that all directors should be financially literate—and, consistent with NASDAQ, define this as the ability to read and interpret financial statements.

To effectively interpret financial statements, it is obviously helpful to know the standards that apply to them. This means not only understanding the financial numbers, but also some idea of how to account for and audit those numbers.  Given the complexity of auditing and accounting standards today, this is not easy—not even for the “audit committee financial expert” that Sarbanes-Oxley rules first required for all audit committees almost a decade ago.

Yet A&A literacy is achievable—just ask! That’s what I’ve been doing for the past few decades while working with accountants and auditors on a number of projects—most recently a collaboration of the Center for Audit Quality (CAQ), the Financial Executives International, and The Institute for Internal Auditors with the NACD to find innovative ways to combat financial reporting fraud. As a group, I find these A&As typical of the profession: full of diligence and integrity—and governed by a growing number of standards.

Complex Challenges, Simple Solutions

Over time, I’ve identified at least seven complex challenges that thwart understanding of A&A:

1. Similar or identical A&A acronyms.
2. Overlap between A&A professions, and shared use of the word “auditor” for both internal controls and external reviews.
3. Shared turf between A&A standard setters.
4. Periodic changes of the names/numbers of A&A standards.
5. Growth in the number of mandatory A&A standards and standard-setters.
6. Growth in the number of voluntary A&A standards and standard setters.
7. Global convergence of A&A standards.

This blog will define these challenges and propose simple tips that all directors can use. At the end of this article, there is a list of the 20 most crucial acronyms for A&A standards and standard setters. As a director, you will want to learn these terms. But before you do, consider my advice on how to keep it simple.

Complex Challenge 1: Similar or identical A&A acronyms.  At a board meeting, hearing about A&A standards, just to start with the beginning of the alphabet, you may hear the letters AS, ASB, ASU, AT, AU, followed by numbers. Do you really know which are accounting standards, and which are audit standards, and what they mean? (See the handy glossary below.) Getting to the letter I in the alphabet of A&A, the soup thickens. Recently, I learned that there was an IAASB as well as two different IASBs. I had the same second-grade impulse to strike a match! I calmed down when I learned that whereas the IASB is the International Accounting Standards Board, the other IASB is the Internal Auditing Standards Board, and the IAASB is the International Auditing and Assurance Standards Board. Might some nonexperts serving on audit committees drown in the alphabet soup?

Simple Tip 1: Call things by name. When you are in a board or committee meeting, whether you are a director or an advisor, don’t just use an acronym and number—and don’t let anyone get away with one. Use or insist upon the name of the standard. For example, instead of Topic 820 (or worse yet FAS 157, in the pre’99 parlance), call it “fair value accounting.”

Complex Challenge 2: Overlap between “accounting” and “auditing” professions—and use of the term “auditor” for both external and internal auditors. Auditing and accounting are different yet intertwined. It’s notable that the main U.S. standard setter for audit standards does not have audit in its name. It is called the Public Company Accounting Standards Board—even though it sets standards for auditing, not accounting! Similarly the IAASB (for “Audit” standards) is run by the International Federation of Accountants.

To make matters more complicated, the word “auditor” by itself means someone who works for an audit firm. However, the term “internal auditor” means someone who works for a company that gets audited by such a firm. The work of these two types of auditors is entirely different. The external auditor, as mentioned earlier, reviews the work of accountants. The internal auditor is responsible for what are called internal controls—the system of checks and balances that ensures an environment conducive to proper accounting and reduces the chance of error or fraud. Standards for each of these groups—accountants, auditors, and internal auditors, are set by three different authorities.

Simple Tip 2: Keep the As straight.  Think of it this way. Accountants apply accounting standards to create financial statements, internal auditors set internal controls, and auditors audit the results. All three are necessary for good financial reporting and each needs separate professional standards.

Complex Challenge 3: Shared turf between accounting- and audit-standard setters. Because auditors essentially check the work of accountants, and both accountants and auditors must be CPAs, it is not surprising that there is some overlap between the turf of standard setters. An example of this would be the overlap between the American Institute of Certified Public Accountants (AICPA) and the Public Company Accounting Standards Board (PCAOB).  The AICPA sets standards for private company auditors, and the PCAOB sets standards for public company auditors. However, unlike the AICPA, which has been in existence since 1897, the PCAOB is relatively young (10 years old) and has set only 15 Audit Standards so far (this is not counting other types of documents produced by the PCAOB such as concept releases). Where the PCAOB has not set an audit standard, called an AS, and where the AICPA has not set a statement of audit standard, called an SAS, companies are expected to follow by default the applicable audit standard set by the AICPA, called an AU.

Simple Tip 3: Give it to the committee “expert.” This is a particularly complex area. To maintain simplicity, the designated audit committee financial expert can shoulder this burden, assisted perhaps by an occasional educational session for the full board. Directors can take comfort in knowing that public company auditors are overseen by an independent board—the PCAOB. The AICPA has overseen private company auditors for more than 100 years.

Complex Challenge 4: Periodic changes of the names and content of accounting and audit standards.  By now all audit committee members know about the FASB Codification project that renamed the GAAP standards definitively in July 2009. A few years back, I was writing a long treatise on U.S. accounting standards under the Financial Accounting Standards Board (FASB), such as the famous FAS 157 and its sequel 157R on fair value accounting. But along came a change that renamed and renumbered all of the standards.  FAS 157 is now Topic 820. The global landscape has also shifted nomenclature. From 2004 to 2009, the Clarity Project of the International Accounting Standards Board improved International Standards for Accounting (ISAs), which are now referred to as International Financial Reporting Standards (IFRS).

Simple Tip 4: Learn the code! As mentioned earlier, it’s a good idea to use descriptive words rather than numbers when referring to a standard. In addition, if you are going to learn any numbers, the FASB Codification scheme is worth learning. Being only a few years old, and very well organized, it’s not likely to change in our generation.

Complex Challenge 5: Growth in the number of mandatory A&A standard-setters and standards. Currently, there are at least eight separate entities that are responsible for accounting and/or audit standards, more than 1,000 accounting standards, and dozens of audit standards—domestic and international. Thanks to monumental efforts by standard setters and the professionals helping them, the standards are logically ordered and clearly labeled. The main problem is the sheer amount. No single human brain can possibly know them all. Certainly an experienced accountant and/or auditor can help familiarize the board and the audit committee with the most important standard setters and standards.

Simple Tip 5: Make a list.  Make your own list of the important acronyms.  For a one-page guide to the 10 main standard setters and the 10 main acronyms they use, see the lists at the end of this blog.

Complex Challenge 6: Growth in the number of groups setting voluntary standards to supplement the mandatory standards. I was recently given an excellent guide to A&A organizations and their acronyms from a colleague in the standard-setting profession. In addition to the eight standard setters listed below in this blog, the list had 10 more, including the above-mentioned organizations (CAQ, FEI, IIA) and the longstanding Committee of Sponsoring Organizations of the Treadway Commission (COSO), which has suggested voluntary standards for internal controls for a quarter century.

Simple Tip 6: Prioritize your attention. As valuable as suggested practices are, mandatory standards come first. So, for example, a PCAOB standard on risk oversight would have more weight than a COSO standard, no matter how valuable the latter may be.

Complex Challenge 7: Convergence of accounting and audit standards globally. For years we have been hearing that accounting standards are converging into a global standard. The FASB and the IASB are currently holding meetings, slowly but surely creating joint standards. So far, the IASB has either completed or is working on more than 30 International Financial Reporting Standards (IFRS). That’s only about 3 percent of the way through the 1,000 we have in the United States.—and some may remain forever American—but it’s a trend worth watching.

Simple Tip 7: Request a “short list” of global A&A standards. It is beyond the call of duty for directors to master convergence by themselves. Here is a good area for professional assistance. Ask your external audit firm to provide a short list of the global accounting and audit standards that impact your operations most critically—along with notes about what they mean for the company. Given the slow progress of convergence, this is not an impossible task—and can broaden your A&A horizons.    

Conclusion

Don’t get me wrong. I have profound respect for the accounting profession and the various professionals who hold the title of certified public accountant (CPA). They rival corporate directors as a group endowed with a keen sense of integrity and service on behalf of the enterprises they serve.  Personally, however, I wouldn’t want to do their work. They deserve every penny they make, precisely because of all the names and numbers they must learn and remember to do their jobs.

In closing, here are the acronyms I have collected as must-knows for all of us. Good luck, and please keep all matches away from me!

20 MUST-KNOW ACRONYMS FOR A&A STANDARD SETTERS AND STANDARDS

These lists only include mandatory or unique standards and the bodies that set them. It does not include the many organizations that support this fundamental work through additional voluntary standards.  (See No. 7)

Acronyms for Standard-Setters

AICPA – American Institute of Certified Public Accountants – standard-setter for accounting and auditing of private companies.

ASB – Audit Standards Board of the AICPA – standard setter for private company audits. This board oversees the AU standards of the AICPA.  The AU standards are numbered from 110 to 901. They are interim standards unless they are superseded by an SAS. There are 121 of the SAS standards (SAS 1-SAS 121).

FASB—Financial Accounting Standards Board—standard-setter for U.S. accounting rules. The FASB, along with its predecessor the Accounting Principles Board, has set standards in Topic Areas, as well Exposure Drafts to test ideas. Topics, which are authoritative, cover nine areas numbered 105 (General Principles) through 995 (Industry Standards). Each Topic has drop downs with one to 10 further topics, each of which in turn has several more topics. All in all, counting all three levels of topics, there are some 1,000 topics. 

IASB—International Accounting Standards Board—This group has either completed or is currently working on more than 30 standards, called IFRSs.  See also the IASB below

IAASB—The International Auditing and Assurance Standards Board—part of IFAC. The IAASB has issued 36 standards for auditing and assurance numbered 200 through 810.

IASB—Internal Auditing Standards Board—This group sets standards for internal auditing internationally. It is part of The IIA.

IFAC—International Federation of Accountants—standard setter for international standards of audit and assurance (via IAASB). See IAASB.

IFRS Foundation—With the IASB, sets international accounting standards. See IASB.

The IIA—The Institute of Internal Auditors—sets global standards for internal auditing. The long name of these are International Standards for the Professional Practice of Internal Auditing, globally nicknamed IPPF. These Standards are numbered 1000 through 2600. Standards vary in length and complexity, but some are many pages long, containing numerous subtopics.

PCAOB—Public Company Accounting Oversight Board—setter of U.S. auditing rules. The PCAOB has set 15 Audit Standards (AS1-AS15). It also has posted 18 professional standards, called Rule 3100 through Rule 3700. It also has posted the AICPA’s AUs (see AICPA). The PCAOB also publishes Concept Releases to text ideas before they become proposed standards.

Acronyms for Standards

AS—Audit Standards—standards set by the PCAOB

ASU-—Accounting Standard Update—Updates to accompany the Topics in FASB. (Ever since Sept.15, 2009, Topics replaced SFASs name and numbers.)

AT—Interim Attestation Standard—adopted by the PCAOB as an interim standard for an aspect of auditing; based on AICPA audit attestation standards.

AU—Interim Audit Standards of the PCAOB and shared by the AICPA. (The “A” and “U” do not stand for words.) Each AU is authoritative unless and until it is superseded by an SAS.  Each AU is consistent with and draws from one or more SASs.

GAAP—Generally Accepted Accounting Principles—standards set by FASB.

GAAS—Generally Accepted Auditing Standards—standards set by the ASB of the AICPA.

IFRS—International Financial Reporting Standards—set by the IASB and IFRS Foundation; supersede IAS standards.

ISA—International Standards on Auditing—from IAASB.

SAS—Statement on Auditing Standard—an authoritative standards from AICPA.

Topics—the new name given to accounting standards under FASB’s Codification.

The following acronyms are superseded (or waning) but still being referenced by those who have not learned the new nomenclature.

FAS—Financial Accounting Standard—old name for standards issued by the FASB—also called SFAS (for Statement of Financial Accounting Standard).

IAS—International Accounting Standards—currently being superseded by IFRS.

The Jumpstart Our Business Startups Act, or simply the JOBS Act, achieves two major objectives: reducing cost and regulation for smaller companies seeking to go public and allowing for “crowdfunding” to solicit small investments, typically through the Internet. The legislation creates a new category of issuers with the Securities and Exchange Commission (SEC), called “emerging growth companies”—those with total annual gross revenues of less than $1 billion during the most recently completed fiscal year.

The new law scales back existing regulations in favor of allowing easier access to capital markets for smaller companies. Top among the reduced regulations is a decrease in auditing mandates. Currently, under Sarbanes-Oxley (SOX), public companies are required to pay an outside auditor to attest to an assessment of the company’s internal controls and procedures. The JOBS Act eliminates this requirement for the emerging growth company and will likely save small issuers millions of dollars in the process. Additionally, the emerging growth company will be required to show only two years of audited financial statements as opposed to three under the original SOX rule. Finally, in any registration statement to be filed with the SEC, an emerging growth company will not need to disclose financial data for any period before the earliest audited period presented in connection with its initial public offering.

The JOBS Act does not stop at SOX-era reductions; the new law also addresses the recent corporate governance provisions of Dodd-Frank. The act removes the need to hold say-on-pay and golden parachute votes on executive compensation.

Companies may only benefit from the emerging growth category for a limited time. There are four scenarios that will trigger a company’s exclusion from the emerging growth category. The first exclusion is triggered when the company’s annual gross revenues meet or exceed $1 billion. Alternatively, a company would be excluded after five years in the emerging growth category. The next and final two scenarios involve the company issuing over $1 billion in non-convertible debt or becoming a large accelerated filer.

In passing this law, Congress also took the opportunity to address some recent developments coming from the Public Company Accounting Oversight Board (PCAOB). Emerging growth companies will be exempt from any possible future rules requiring mandatory audit firm rotation or supplements to the auditor’s report in which an auditor would be required to provide additional information about the audit and the company’s financial statements, sometimes referred to the auditor’s discussion and analysis (AD&A). These limitations on the audit firm rotation and auditor’s reports are only speculative, as the PCAOB has only issued concept releases on the issues.

Opponents to the rule argue that the JOBS Act removes shareholder protections. Ann Yerger, of the Council for Institutional Investors (CII) said the act “will create greater risks for investors and ultimately could erode confidence in our capital markets.”

While NACD shares CII’s concerns, it supports the JOBS Act and sees it as a vehicle to reduce costly and burdensome regulations for small companies seeking access to the capital markets to grow their business. The benefits of this act, combined with well-functioning boards, outweigh the need for additional and costly shareholder protections. It is a board’s responsibility to protect shareholders by ensuring that the company is operating efficiently and ethically. While regulations can provide some measure of assurance, there is no replacement for a board when they have the right tools, education and shareholder input.

Those supporting mandatory audit firm rotation were primarily concerned with a perceived lack of independence in audit engagements. They contend that long-term audit engagements have the potential to weaken the auditor’s work performance. Under the current system, these critics argue, audit firms may try to please their clients in order to keep the engagement instead of remaining objective. As panelist Richard Kaplan, professor of law at the University of Illinois at Urbana-Champaign, put it, “Auditors are prone to bias their conclusions to best preserve the client relationship that pays their bills.” 

Panelists opposed to tenure limits for auditors dismiss this argument for lack of clear and convincing evidence. As Greg Jenkins, professor at Virginia Polytechnic Institute and State University, noted in his opening statement, “The academic findings on auditor rotation are mixed with no clear picture as to whether rotation is beneficial. Adding to this lack of clarity, is the increasing realization that the association between auditor tenure and audit quality is rather complex.” In other words, in the battle to improve audit quality, mandatory firm rotation is not a magic bullet.

Alex Mandl, chairman of the audit committee at Dell, shared the director’s perspective on behalf of the National Association of Corporate Directors. Mandl stressed that audit committees have dramatically improved their performance since the passage of Sarbanes-Oxley. While there is still room for improvement, mandatory audit firm rotation is not the appropriate method, he said. In her comments, Catherine Lego, chairman of the audit committee at SanDisk, suggested that audit quality improvement may lie in the education and training of directors. Greater audit committee engagement with the PCAOB and director education groups such as NACD, may be the most effective route in maintaining proper oversight of audit firms, she asserted.

NACD submitted a comment letter on this issue to the PCAOB in December. While NACD supports the PCAOB’s initiative to improve audit quality, NACD believes a term-limit system may be the wrong approach. This comment letter outlines five major issues with the proposal as drafted:

• The board and audit committee are uniquely qualified to evaluate the work of an audit firm.
• The board and audit committee have a statutory responsibility for the oversight of auditors. Mandatory audit firm rotation supplants this authority.
• Audit firm rotation is unnecessary for objectivity, since there is already a requirement for mandatory audit partner rotation—as well as rules for auditor independence.
• Developing an understanding of the company may take auditors years to develop and can require even more time to deliver the maximum benefits.
• Mandatory audit firm rotation is disruptive and costly, particularly in special situations.

A formal proposal on this topic is still months away, if at all. NACD looks forward to engaging with the PCAOB, as well as the director community, on this important issue.

Much like with our bodies, our boardrooms can benefit from the same type of comprehensive, annual examination.

Just like our bodies can get sick, our boards can also struggle without attentive care to their needs, and it’s important to have independent experts who can conduct a thorough review of board performance. Directors should make it a priority to ensure that their boards are getting the proper maintenance and their fellow directors are providing the highest quality of service to their peers and to the company they’re overseeing.

Conducting routine board maintenance—aka a board “exam” —is an important step toward long-term boardroom health, and an independent third party is often well-positioned to prescribe strategies to bring boards up to par.  Healthy boards enable directors to fire on all cylinders with management, which ensures peak performance company-wide.

NACD’s Board Advisory Services is an example of an independent third party that is well-positioned to confidentially conduct board maintenance—with the expertise, confidentiality and analytically driven insights and knowledge to identify a board’s strengths and potential vulnerabilities. We know how to make the tough calls and provide the best strategic advice to strengthen boardroom performance—both as a cohesive whole and as a collection of individual directors. And we have the essential tools to dive deep into the issues today’s boards face—expert facilitators and the ability to analyze every board and director from a neutral standpoint.

In addition to independence, it’s important that any party evaluating your board be thorough and administer the right tests. Through personal interviews, as well as qualitative and quantitative evaluations, NACD can gather the necessary information, consolidate the data and look for key themes. By collaboratively establishing a talent matrix based on the current and future composition of your board, we can highlight the individual skills and attributes of board members and help identify the areas you should consider for effective succession planning. This quality, independent analysis is essential to a board looking to function at maximum efficiency.

Like your annual physical, a regular check up is a useful exercise to help your board prepare for a prosperous future, and the importance of using an independent third party to conduct recurring board maintenance cannot be overstated.

As the only organization serving as the voice of the director, NACD is aware of the burdens that mandatory audit firm rotation places on boards and businesses alike. The turnover of audit firms could undermine the board’s duty to evaluate the firm’s work as required under the Sarbanes-Oxley Act of 2002.

Auditor rotation may accomplish the PCAOB’s intended goals but it has not yet shown this process to be cost effective nor has it shown that it would enhance financial reporting. On behalf of NACD’s nearly 12,000 members, we’ve submitted a comment letter to the PCAOB on this issue, outlining our five major issues with the proposal as drafted.

1. The board and audit committee are uniquely qualified to evaluate the work of an audit firm.

The board of directors, and more specifically the audit committee, is best positioned to judge the effectiveness of an auditor. An audit committee will possess the necessary objectivity to make this judgment. Furthermore, the committee will understand the most important aspects of a company’s strategy, financial reporting and internal controls. As such, along with the board, the audit committee is uniquely qualified to evaluate the work of an auditor and, if appropriate, to renew the auditor’s contract of engagement. Limiting the tenure of an auditor through mandatory firm rotation would infringe upon the committee.

2. The board and audit committee have a statutory responsibility for the oversight of auditors. Mandatory audit firm rotation supplants this authority.

Reducing the board’s options to keep an existing auditor runs counter to the spirit of existing law. Audit committees are directed to appoint, compensate and oversee the external auditor. These requirements came from the implementation of SOX. The act established qualifications for audit committee members and delegated specific responsibilities to protect the shareholders’ interest in accurate financial reporting.

Mandatory audit firm rotation would supplant the statutory responsibility and authority of audit committees to select the best auditor for a company and oversee its work. The authority of the board and its committees is at the heart of the corporate governance framework, and reducing that authority would result in weakened oversight and guidance directors provide for U.S. companies.

NACD believes change should occur based on the performance of the auditors—not an arbitrary timeline. Boards of directors should constantly assess the value an outside auditor is bringing to the company. When performance is lacking, a board of directors must step in and make a change. This type of assessment takes time and effort, but boards and audit committees are dedicated to the task.

3. Audit firm rotation is unnecessary for objectivity, since there is already a requirement for mandatory audit partner rotation —as well as rules for auditor independence.

Under current rules implemented under SOX, there is a requirement to rotate the lead partner in audits every five years, with a cooling off period of another five years. Having a new audit partner in charge ensures objectivity. In addition, the audit profession has spent years defining ever more stringent rules to define auditor independence. It would be difficult in this day and age to find a single auditor or audit firm with conflicts of interest in relation to the audited client. This regulatory framework already ensures the objectivity desired by proposed firm rotation, rendering firm rotation unnecessary. 

4. Developing an understanding of the company may take auditors years to develop and to deliver the maximum benefits.

On a practical level, mandatory rotation may also reduce the quality of an audit. It is common knowledge that quality audits are dependent upon the auditors’ understanding of the company. As an audit firm’s institutional knowledge of a company grows, so does its ability to identify critical issues. This understanding often takes years to develop.

5. Mandatory audit firm rotation is disruptive and costly, particularly in special situations.

Mandatory rotation forces a change that may not only be undesirable, but is disruptive and time-consuming. This is particularly true in times of corporate change. For example, a need to change auditors during M&A transactions, corporate financing or a change in management could prove daunting. A confluence of events such as this would greatly expand the cost and difficulty of the transaction or transition and potentially hamper an effective audit of the company. The time and resources required for management and audit committees to manage all of these transitions would be significant. Moreover, the additional work required for a new firm to get up to speed would add cost and possibly delay to the audit.

Call to action:  Please join me contacting the PCAOB to let your voice be known.

Without any legal requirements or generally accepted best practices in this situation, NACD went to the experts for an opinion—our members. A one-question survey in last Friday’s Directors Daily asked: Do you think the Berkshire board’s choice to not disclose the identity of Buffett’s successor was appropriate? The majority of respondents, 66 percent, agreed with the board’s decision. Several respondents noted the difference between want and need. While the investors and public would like to know the eventual successor to the Oracle of Omaha, Berkshire does not need to disclose.

Other respondents who agreed with the company’s choice noted the issue of time. Unless Buffett plans to retire in the near future, announcing his successor may encourage competing internal candidates to prematurely leave the company. Furthermore, such a disclosure would effectively lock Berkshire to a candidate who—with an undefined timetable—may be unable to take the position at Buffett’s departure. Lastly, several members responded that they simply trusted Buffett’s business acumen.

The remaining third who disagreed with the Berkshire board’s decision largely cited a lack of transparency. By not announcing the successor’s identity, the company creates tension and suspense, which could detract from internal morale. These respondents generally believed that investors were entitled to such transparency—unless Berkshire would be materially damaged by disclosing.