Today, audit committees are universal and the national stock exchange(s) have listing requirements for them. Such requirements are modeled after the Blue Ribbon Committee (BRC) on Improving the Effectiveness of Corporate Audit Committees recommendations. In December 1999, the SEC, the national stock exchange(s), and the Auditing Standards Board issued new rules largely based on the recommendations by the BRC. Thus, best practices dealing with matters such as independence, qualifications, charters, outside auditor involvement, and reports became law.

The audit committee should be informed about the financial and operational aspects of the company and, therefore, should receive sufficient and timely information. If the audit committee meeting is scheduled to coincide with the regular full board meetings, then the committee must receive written information well in advance of the meetings.

To be vigilant, the audit committee should ask probing questions about the propriety of the company's financial reporting process and the quality of its internal controls. This task requires the committee to keep abreast of financial reporting developments affecting the company.

The Audit Committee Handbook, 3rd Ed. Louis Braiotta, Jr., Richard S. Hickok, John C. Biegler Now in its Third Edition, The Audit Committee Handbook, 3rd Edition is the only comprehensive reference that provides guidance to all functions, areas, duties, and responsibilities of audit committees as well as their direction in the corporate government context.

To be an effective independent overseer, the audit committee must be positioned between senior management and the external auditors. This organizational structure allows the audit committee to question management's judgments about financial reporting matters and to suggest improvements in the internal control systems. The committee's charter defines its mission, duties, and responsibilities; plans its annual agenda; and documents its findings and conclusions.

Failure on the part of the audit committee to review and evaluate the financial statements and related accounting policies in accordance with generally accepted accounting principles is clearly malfeasance.

One of the conclusions from the Report of the Special Investigation Committee of the Board of Directors of Enron Corporation (Powers Report" was:

"The Board, and in particular the Audit and Compliance Committee, has the duty of ultimate oversight over the Company's financial reporting. While the primary responsibility for financial reporting abuses discussed in the Report lies with management, the participating members of the Committee believe those abuses could and should have been prevented or detected at an earlier time had the Board been more aggressive and vigilant." (p. 24)

While a review of Enron's annual proxy statement as of March 27, 2001 reveals compliance with the final disclosures rules on audit committees, a closer examination of the factors indicative of financial reporting risk by Enron's audit committee would have minimized the potential for class-action suits by recognizing the warning signals that lead to fraudulent reporting.

For example, red flags that fraudulent financial reporting may be occurring (and the appropriate action item) include:

• Over optimistic news release with respect to earnings. Action item: Analyze annual and interim earnings trends to avoid increased opportunities for managing earnings
• Industry accounting practices in contrast to unusual revenue recognition policies to increase earnings. Action item: Access significant accounting policies that are industry-specific from a financial reporting data base and review this information with both internal and external auditors.
• Rapid growth of the organization. Action item: Investigate reasons for rapid expansion in relationship to both top-line and bottom-line double-digit annual growth rates as well as significant increases in year-to-year changes relative to past performance.
• Significant changes in accounting practices and estimates by management with an excessive interest in earnings. Action item: Compare these changes with industry norms and determine the reason for them.
• Conflict-of-interest and significant contracts that affect financial statements. Frequent related-party transactions and failure to enforce the corporate code of conduct. Action item: Determine management's intent to disclose such contracts as well as how the firm addresses conflict-of-interest situations and monitors compliance with the code. If necessary, conduct or authorize a special investigation and retain independent counsel and other professionals.
• Unexplained significant fluctuations in account balances Action item: Focus on analytical review procedures and discuss the findings with both internal and external auditors.
• Breakdowns in the system of internal control. Action item: Obtain assurance from both the internal and external auditors that management has evaluated the weaknesses and recommendations in the management letter and that corrective action has been taken.
• Scope restrictions placed by management on both the internal and external auditors. Action item: Give assurance to the auditors that they have unrestricted and free access to the audit committee.

Audit committee members should be highly attuned to the potential of fraudulent financial reporting. Failure on the part of the audit committee to question management's representations may be the basis for audit committee malfeasance, since the audit committee and the board may be held liable for failure to know what they were responsible for recognizing.

Louis Braiotta, Jr., MBA, CPA, is Associate Professor of Accounting at the State University of New York at Binghamton. His e-mail address in braiott@binghamton.edu.