Category: Risk Management

PCAOB’s Proposed Mandatory Audit Firm Rotation Misses the Point

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Last year, when the Public Company Accounting Oversight Board began soliciting comments on ways that auditor independence, objectivity and professional skepticism could be enhanced through mandatory audit firm rotation, NACD felt obligated to share our perspective. While NACD agrees with the PCAOB’s initiative to improve company audits, instituting a term-limit system may be the wrong approach. View NACD’s comment letter at www.NACDonline.org/CommentLetter2011.

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.

 

That Sustainability Show: Heartland, SoCal Chapters Jump Start NACD’s “Why GRI?” Program

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If you want to spark a lively debate in board, just ask about directors’ fiduciary duties of care and loyalty.

  • One director may say, “We owe our duties to our shareowners. Period.”
  • Another director may add, “Yes, but we need to pay special heed to the interests of long-term shareowners. Some shareholders are speculators and not truly owners; they are more like renters.”
  • And yet a third director may say “Why the focus on shareholders alone? As directors, we in fact owe our duties to the corporate entity, and as such, to all its stakeholders.”

If you have a sense of déjà vu it’s because you’ve heard all this before—including the pages of NACD Directorship. It’s a perennial debate.

But no matter which position you take, you must agree that over the long term, the interests of shareholders and other stakeholders all converge. And furthermore, you must agree that to serve those interests requires that a company be sustainable—that is, able to stay in business over the long term, and not crash due to some unforeseen and/or managed risk—including an environmental or social risk.

So how can investors and other stakeholders gain confidence on that score? Enter the Global Reporting Initiative (GRI), the globally accepted standard for reporting nonfinancial information about a company.  In a series of recent chapter programs, NACD has been introducing the topic of GRI to our membership in a show affectionately nicknamed the “Why GRI?” show.

GRI Who?

When the Global Reporting Initiative  first opened an office in the United States in October 2010, its acronym – GRI – drew mostly blank stares in U.S. boardrooms. Although a majority of the largest global companies were using this template for reporting nonfinancial data, American reporters were relatively few in number and low in profile.  Today, after a mere 18 months of promotional efforts by a US-based director, GRI is becoming a familiar name. Indeed, as of February 2012, nearly 250 U.S. organizations now report on their sustainability using the GRI template—almost double the number that reported prior to the US office launch. And even more important, there is a growing awareness that GRI is not merely about reporting: this reporting initiative seeks to improve the quality of corporate strategy and risk oversight—and therefore corporate value itself.

GRI Now!

One catalyst for the new and deeper GRI awareness has been a series of NACD chapter programs being generated at the grass roots level. Combined attendance at the first two events topped 100—a decent number for a topic that is relatively new to U.S. boardrooms.

The Kansas City Program

I’m going to Kansas City. Kansas City here I come!  Appropriately for a dynamic start, the inaugural program started  when Laura McKnight, co-chair of the chapter with Charles Peffer, invited GRI’s US Director Mike Wallace to address the Heartland Chapter in November 2011, along with EMC’s chief sustainability officer Kathrin Winkler.  As chair of the Greater Kansas City Community Foundation, McKnight understands the importance of corporate social impact.

During a breakfast panel on “The Board of Directors and Corporate Sustainability,” Winkler explained how her board oversees her corporation’s social and environmental presence. At EMC, management regularly reports on sustainability matters to the EMC governance committee and the full board.

At least twice a year, the chief sustainability officer provides an update to the EMC governance committee on sustainability initiatives and progress. Topics discussed on the EMC board to date include stakeholder engagement—including feedback from customers and relations with employees. Furthermore, sustainability discussions play a major role in board discussions of the company’s strategic plans and the board’s related oversight of risk. More details on EMC’s program will be forthcoming in the March-April 2012 issue of NACD Directorship.

The LA Program

From this pioneering start in the Heartland came an even more ambitious program in the City of Angels, focusing on “Corporate Strategy and Reporting in a Global Economy: the Board’s Converging Roles.”  Held at the historic California Club in January 2012, the Southern California Chapter event attracted the leaders of the LA business community, including Dann Angeloff, Chairman Emeritus of the chapter, and a Lifetime Member of NACD, in recognition for his 35 continual years of membership. Dann was the seventh person to join NACD—back in 1977, and he looks as young as ever (good governance is good for your health). But not all attendees were local. Richard Crespin, executive director of the Corporate Responsibility Officers Association attended as well—traveling all the way from Washington,DC.

Program chair Fay Feeney, CEO of Risk for Good, a governance consultancy that supports GRI as an Organization Stakeholder, moderated a panel featuring GRI’s Wallace plus three others: Mary O’Malley, Chief Sustainability Officer, Prudential; Chad Spitler, Director Corporate Governance and Responsible Investment, BlackRock; and Mary Ann Cloyd, Partner, Center for Board Governance, PwC.

The invitation to the event framed the issue precisely:

Boards are increasingly involved in helping to develop and monitor sustainable corporate strategies. At the same time, board oversight of corporate reporting has grown as well. So what is a board to do?  How will you provide oversight as a Director? 

When it comes to strategy, boards are faced with tradeoffs between short term and long-term gains, and differing interests of stakeholder groups. When it comes to reporting, we have the SEC, FASB, IFRS, GRI, ISO, Carbon Disclosure Project and IIRC–all of which are providing guidance and/or standards to companies about reporting.

Add the fact that there are an increasing number of shareholder proposals seeking disclosure on a wide variety of environmental and social issues, and shareholders with strong views on both sides of these issues … what is a company to do?

After an introduction from Chapter President Chris Mitchell, Feeney set the stage by pointing out that today a major percentage of any company’s value lies in intangibles rather than tangible assets. How right she is! In a very real sense, reputation is worth more than money. As Shakespeare wrote, “Who steals my purse, steals trash… but he that filches from me my good name …makes me poor indeed.” (It so happens that a villain said this in a tragedy but it is still true!) Feeney also pointed out the many names that sustainability may take on: corporate social responsibility, corporate citizenship, sustainable development, and so forth. It’s all about having a “meaningful conversation around value,” said Feeney.

Wallace explained the GRI reporting system as a highly adaptable model for reporting nonfinancial information in a variety of organizational types—in most cases on a voluntary basis.  In the U.S., company managers report sustainability on a voluntary basis as a way of informing the board, stockholders, and others about their companies’ social imprint. But Wallace noted that some governments and stock exchanges outside the U.S. are making GRI reporting mandatory for companies and their suppliers, and these mandates are touching U.S. companies as foreign and domestic buyers ask U.S. companies to disclose sustainability information.  In fact, Microsoft and Apple are both asking their key suppliers to produce sustainability reports according to GRI. Being a GRI reporter prepares companies for these unfolding compliance demands.

In his remarks about investment styles, BlackRock’s Spitler hammered home a key point. Investors may have differing expectations, including social expectations, but Blackrock favors GRI reports for financial, rather than moral, reasons. BlackRock wants to make sure the company is a good financial bet for the long term and GRI reports make it easier to compare companies’ non-financial performance.  Spitler explained that while there may be some very good information about a company in these SEC reports, much may be missing. And when companies put out their own reports on their activities in the world, it is not always easy for shareholders and others to compare one company to another as they may use different terms and categories. For many years, to compare sustainability across firms was like comparing apples to oranges to aardvarks, one might say. GRI makes the comparisons easier or shareholders—a point emphasized by Spitler.

Bringing in a high-level corporate perspective, O’Malley described the history of the reporting program at Prudential, making a very useful point for beginners. The purpose of sustainability reporting, she said, is not to brag about how sustainable we are. Its aim is set sustainability goals, disclose the goals, and reveal how far along the company is in achieving them. In short, sustainability is not a destination; it is a journey.

Rounding out the discussion from a boardroom perspective, Cloyd of PWC underscored the need for director attention to information about various stakeholder issues, as a matter of risk oversight as well as strategic opportunity.

Summarizing comments and T-ing up the peer discussions, Feeney sees this panel as the beginning of a long-term dialogue about matters of strategy and sustainability. Watch this website for an upcoming blog by Feeney on her ongoing peer-to peer discussion program.

Moving On

And there’s more. The next NACD event to feature GRI will be the March 12-13 Master Class in Scottsdale Arizona, where Wallace is slated to copresent with Suzanne Fallender, Director of the Global Corporate Responsibility Office at Intel, a GRI reporter.

And later this year, the Why GRI traveling show will visit new cities. On the horizon: possible events at the New York Stock Exchange and NASDAQ in conjunction with the New York Chapter.

As this road tour makes clear, corporations are more than their revenues minus expenses; more than their cash flow; more than their reportable assets. Corporations are actors on the world stage, interacting with not only investors but also customers, vendors, employees, communities, regulators, and others, and all of these constituencies want to know information about the company that goes beyond financial statements and the 10-K and proxy reports that supplement them. GRI makes this possible. So stay tuned—and stay sustainable!

 

SEC Roundtable on Conflict Minerals Regulations

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On Tuesday, the Securities and Exchange Commission (SEC) convened a roundtable for an area the Commission does not usually delve into: the humanitarian crisis in the Democratic Republic of Congo (DRC). As part of the Dodd-Frank financial reform legislation, the SEC was given the responsibility of drafting rules requiring publicly listed companies to disclose whether their products contain “conflict minerals.” In this context, the conflict minerals are tin, tungsten, tantalum, and gold produced in the DRC or adjoining countries, as well as any others the U.S. Secretary of State may designate as financing conflict in the DRC.

Although the SEC issued proposed rules on the disclosure in December 2010, it has since failed to meet its April deadline established for final rules, citing difficulties in drafting a rule that would not pose prohibitive costs of compliance for companies. To this end, the SEC convened a public roundtable representing corporations, investors and human rights advocates.

The first panel discussed what is covered by the rule, and what steps would be required to comply. Panelists included Sandy Merber, General Electric; Irma Villarreal, Kraft Foods Inc.; Yedwa Zandile Simelane, AngloGold Ashanti Ltd.; and Mike Davis, Global Witness. The panel discussed a series of questions the Commission had developed from the first round of comment letters including:

  • Should functionality be a test of whether a product is included in the report?
  • If the mineral is used as an ornament, should it be included?
  • Should rules include a de minimis point?
  • How to define “contract to manufacture” in rules

Unlike many of the rules to develop from Dodd-Frank, this did not trigger contention among those representing corporations, investors and advocacy groups. While the representatives from Kraft Foods and General Electric noted the practical impossibility of fully identifying the sources of all their products by the next reporting season, the other panelists, recognizing this, responded that they would be content with a “good faith” effort, improving year over year. Even so, the sheer scope of the rule’s potential impact demonstrates the difficulties the SEC faces in writing the rules, and for companies to comply. Villarreal noted that Kraft Foods has 40,000 different products with 100,000 suppliers.

The second panel continued to discuss the steps necessary for compliance as well as reporting. Panelists included Benedict S. Cohen, The Boeing Company; Jennifer Prisco, TE Connectivity; Darren Fenwick, Enough Project; Kay Nimmo, ITRI, Ltd.; and Darrel Schubert, Ernst & Young LLP and the Auditing Standards Board. Picking up where the first panel left off, the roundtable discussed further questions from the SEC, such as:

  • Should the disclosure be included in the annual report or in a separate report?
  • Should scrap and recycled minerals be exempt?
  • How should the country of origin be defined?
  • Who should conduct the audit? A Certified Public Accountant (CPA), or non-CPA?
  • Should the SEC specify a standard for the audit, and, if so, what standard?

The SEC faces a difficult task—draft rules that satisfy the Dodd-Frank requirements and advocacy groups, without imposing punitive costs or unattainable expectations on corporations. In light of the recent dismissal of proxy access rules from the U.S. Court of Appeals, the SEC must also create rules that will survive potential court challenges. As the voice of the director, NACD is currently drafting a comment letter. Stay posted for further developments in this area.