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SEC Central
The Audit Committee Financial Expert

July 2003On January 24, 2003, the Securities and Exchange Commission issued a corrected final rule implementing Sarbanes-Oxley Section 407, which requires a public company to disclose that it has at least one "financial expert" on its audit committee or, otherwise, to explain why it does not. Under this rule, the board of directors determines whether or not the board should include a financial expert as part of the audit committee. Although this is framed as a disclosure rule, pressure from either the investment banking community or shareholders will require many boards to ensure that a financial expert is a member of the audit committee.

Under the rule, as adopted, to qualify as a financial expert the director must have five attributes:

(i) an understanding of GAAP and financial statements; 

(ii) the ability to assess the general application of such principles in connection with the accounting for estimates, accruals and reserves;

(iii) experience preparing, auditing, analyzing or evaluating financial statements that present a breadth and level of complexity of accounting issues that are generally comparable to the breadth and complexity of issues that can reasonably be expected to be raised by the registrant's financial statements, or experience actively supervising one or more persons engaged in such activities;

(iv) an understanding of internal controls and the procedures for financial reporting; and

(v) an understanding of audit committee functions. 

These attributes may be acquired in one or more of four ways:

(i) education and experience as a principal financial officer, principal accounting officer, controller, public accountant or auditor, or experience in one or more positions that involve the performance of similar functions; 

(ii) experience actively supervising a principal financial officer, principal accounting officer, controller, public accountant, auditor or person performing similar functions;

(iii) experience overseeing or assessing the performance of companies or public accountants with respect to the preparation, auditing or evaluation of financial statements; or 

(iv) other relevant experience.

The final rule reflects criticism that the rule as originally proposed would only permit certified public accountants, who had previously audited public companies, as the sole group of persons that would qualify as a financial expert. In other words, not even Warren Buffet would qualify as a financial expert. 

On the other hand, the final rule now allows the board to give equal credit for "analyzing or evaluating financial statements presenting accounting issues generally comparable in breadth and complexity." In short, a CEO who has actively participated in and contributed to the preparation of financial statements using GAAP would qualify. Also, prior experience sitting on an audit committee would be an important factor for a board to consider in whether or not someone qualifies as a financial expert. In any event, under this rule the company must disclose the basis for the board of director's determination that someone qualifies as a financial expert. 

In addition to the overall requirements set forth by the SEC, each exchange has the right to set forth its own specific criteria for a financial expert that are not deemed inconsistent with the SEC's five attributes. Companies must comply with the audit committee financial expert disclosure requirements in their annual reports for fiscal years ending on or after July 15, 2003, except in the case of small business issuers, this requirement is for fiscal years ending on or after December 15, 2003.

The impact
The Sarbanes-Oxley Act has had a dramatic impact on the number of independent directors, the role of the audit committee and who will qualify as a financial expert. Currently, there is a shortage of qualified persons who satisfy the financial expert requirements. One practical consideration may be that even if you satisfy the financial expert requirements, you are not designated the financial expert during your initial year of service as a director. In this way, you will have obtained a better understanding of all of the financial aspects that go into the issuer's financial statements before assuming that responsibility. 

The financial expert is required or expected to do more work than the other members of the audit committee, which, in turn, are expected to do more work than the other directors of the issuer. For this, the audit committee and financial expert are entitled to additional compensation. A recent Deloitte & Touche Audit Committee and Governance Survey indicates that the full audit committee, rather than just its chairperson, is now more involved in the review of the company's quarterly press release and 10-Q prior to issuance and filing, respectively.

What's in the works
A House of Representatives bill that would apply the Sarbanes-Oxley "reforms" to mutual funds was recently introduced. In addition, certain states are applying Sarbanes-Oxley type criteria to not-for-profit corporations. Finally, there was a recent case in the Southern District of New York where the court took the position that the directors of a private company are held to the same level of duty and care as those persons that act as directors of public companies, and imposed damages aggregating $44 million.  In view of that decision, a number of privately held, for profit companies may set up an audit
committee with a financial expert. 

The audit committee financial expert is essentially a brand new profession. There are persons who are needed to accept this very responsible position; however, one must initially satisfy the technical requirements to qualify for this position.

More SEC Central articles:

CHARLES HECHT has been a principal of his own law firm specializing in securities law since 1971. He was previously on the staff of the Division of Corporate Finance of the Securities and Exchange Commission at its headquarters in Washington, DC. Mr. Hecht would appreciate any input on subject matters within the SEC accounting area which you believe would be appropriate for a future article.

2003 SmartPros Ltd. All Rights Reserved.

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