April 6, 2020
April 6, 2020
Preparing for a crisis is something most directors have done as part of their role on a corporate board, and directors now find themselves in one of epic proportions: the global health crisis and substantial economic uncertainty caused by the Coronavirus Disease 2019 (COVID-19) pandemic.
The audit committee is front and center, as the financial impact on companies is widespread and maintaining market confidence in reported information on the pandemic’s impact is more critical than ever. It is important that audit committees consider their core responsibilities and keep the below themes in mind.
Most companies will face a very challenging financial reporting period ahead, with nearly 90 percent of PwC-surveyed cross-industry chief financial officers (CFOs) now seeing the potential for significant impact to their business operations from the pandemic, as of March 25. That percentage is up from just more than 50 percent two weeks earlier.
Audit committees are responsible for overseeing how management monitors and controls the company’s major financial risk exposures, including fraud risks. It is critical to maintain the market’s confidence that financial reporting information is reliable, which means it is even more important for audit committees to be focused during a crisis, especially one of this magnitude. Given the complexities in financial reporting right now, the audit committee has to be vigilant and not become overburdened with broader responsibilities.
Now may be the time to shift some of the audit committee’s risk oversight responsibilities to the full board. However, to effectively oversee financial reporting, the audit committee would still need to have access to all relevant risk management information—but maybe some of the detailed oversight can shift to allow the audit committee more time to focus on its core role.
While boards overall are responsible for overseeing the tone at the top, audit committees play a key role. Their challenge is to discern whether the tone that management communicates to the committee is really the tone that permeates the entire company. This is particularly important now that work is being done virtually—employees may feel isolated and disconnected, and messages can be misunderstood. Feedback from past employee sentiment surveys is unlikely to be indicative of the current environment.
Audit committees should consider refreshing questions about whether employees face pressure to bend the rules and whether they think their managers are willing to do so. When they engage with employees in the controllership group, audit committees should consider whether there may be any indications of inappropriate pressure on financial reporting personnel.
Additionally, it is vital to monitor the level of employee complaints, including on the whistleblower hotline. Complaints can be more challenging to resolve in this environment of social distancing, but it’s still critical to pursue them to resolve questions about financials, controls, or even fraud.
An audit committee’s central responsibility is to oversee the integrity of the company’s financial statements and related disclosures. The audit committee provides important links among key parties, such as the internal auditor, management, the full board, and the external auditor. To be effective, the audit committee must have frequent and meaningful interactions with these key parties and be supported by internal resources.
Given the complexity of financial reporting, the work of a knowledgeable and technically competent finance team is vital to an audit committee’s faith in the financial reports it reviews. Most companies are facing disruption and stress, including impacts to closing the books and preparing financial statements.
They are also facing new or different financial reporting matters: changes stemming from rapidly shifting economic conditions as a result of simultaneous, severe disruptions on both the supply and demand sides of the world’s economies and from business strategies moving suddenly from offline, physical-presence businesses to online, virtual-presence ones.
They’re further dealing with lower materiality thresholds based on company performance—80 percent of surveyed CFOs foresee a decrease in revenue or profits (or both) this year as a result of the pandemic. Moreover, they’re dealing with changes in accounting and reporting issues, such as potential impairments, contract modifications, judgments, and estimates, as well as disclosures of liquidity issues, going concern, and other risks.
Audit committees need to consider whether management has a handle on all of these matters. For example, can they provide candid and straightforward answers? Are they willing to acknowledge when they need guidance or need to do further research before providing the answer? Do they need support from outside experts to address some of these issues? Are they working closely with their external auditor to address matters as early as possible?
In some cases, a technical refresher discussion with management, the audit committee, and the external auditor might be needed early in the process to avoid misalignment. Any miscommunication could be substantive since well-reasoned and supported judgments are critical to management successfully issuing financial statements
We don’t know how long this crisis will last. A highly effective internal audit department is an important resource to the audit committee, helping it understand how effectively the company is managing its business risks. In addition, internal audit may allocate significant resources to support management in documenting and testing internal controls over financial reporting.
Understanding changes in priorities, such as delays and deferrals, is vital to making sure there are no gaps in the coverage of what internal audit should do to address key risks. Audit committees should consider if there needs to be a reassessment of rotational or risk-ranked audit, if some should be accelerated (like investigations or identifying changes in the design of control activities), or if some should be deferred (like operational audits). Generally, is internal audit focused on the right topics, in the right time frame, and with the right expertise given the new business environment?
Audit committees have a critical role to play. To do so, they need to stay focused on their key responsibilities, stay vigilant on oversight of tone at the top, recognize that different skills are needed in financial reporting right now, and leverage both internal and external audit.
NACD: Tools and resources to help guide you in unpredictable times.