How to Keep Audit Committees In the Know

American and British regulators agreed recently to an information-sharing arrangement, which they believe would
have helped detect an accounting scheme at Lehman Brothers called Repo 105. Near the end of each quarter, a
UK subsidiary of Lehman would swap some of its assets for cash with a third party, which would sell these assets
back to the Lehman subsidiary for cash just after the end of the same quarter. To reduce the amount of debt on its
balance sheet, Lehman booked these swaps as asset sales rather than borrowings. But regulators alleged that
Lehman engaged in a major accounting fraud by deceiving the public about its true financial condition.

To improve board oversight of financial transactions like Repo 105, it is more important to change the approach of
corporate audit committees than to enhance the information-sharing among accounting regulators. It appears that
members of Lehman’s audit committee were not aware of the many repetitions of the Repo 105 transactions. Their
ignorance says a lot about what is wrong with the current approach to the audit process in publicly traded
companies.

In compliance with the Sarbanes-Oxley Act of 2002 and related exchange rules, all members of the Lehman audit
committee were independent, and the committee’s chair was a financial expert. Following other rules, the audit
committee made sure that the company’s auditor (Ernst & Young) was independent of Lehman, and met privately
with the engagement partner of the audit firm without Lehman management present.

Under Sarbanes-Oxley and related Securities and Exchange Commission rules, Ernst & Young supplied the audit
committee with a list of Lehman’s significant accounting policies. Ernst & Young was also specifically obligated to
report to the audit committee any significant disagreement with management on financial reporting. However, Ernst
& Young apparently went along with Lehman’s accounting treatment of Repo 105. The audit firm and Lehman
relied in part on a letter from UK counsel opining that Repo 105 constitutes a sale under UK law.

In short, to paraphrase Donald Rumsfeld, members of Lehman’s audit committee did not know what they did not
know. Unfortunately, audit committees are often in this state of ignorant bliss. The committee members are
deluged with massive amounts of complex information, including detailed financial statements and lengthy SEC
filings. It is extremely difficult for committee members, no matter how intelligent, to pick out from this mass of data
the key judgments made by management and the external auditors in putting together these statements and
filings.

To become more effective, audit committees should request four specific pieces of information. First, the auditors
should highlight any set of transactions – such as sales or borrowings as well as off balance sheet and taxmotivated
deals – which occur repeatedly at the end of quarters or financial years. It is quite reasonable to design
one complex transaction in response to a unique set of circumstances; it is more suspicious if similar transactions
occur frequently near the end of a reporting period.

Second, the auditors should identify any material item where the accounting literature allows alternative methods
of presentation and explain why the company believes its alternative is preferred. For example, the accounting
literature allows, but not does not require, companies to use hedge accounting in certain circumstances.
Committee members should be fully briefed on whether and why the company decided to use hedge accounting.

Third, and perhaps most importantly, the auditors each year should provide the audit committee with any material
differences in significant accounting policies between the company and its four or five main competitors. This
comparative analysis should cover policies such as revenue recognition, warranty obligations, retirement plan
obligations, tax reserves and valuation of goodwill or other intangibles. Some of the differences in accounting
treatment will be due to differences in how the companies run their businesses; others will represent accounting
judgments that the committee should fully understand.

Finally, the company’s chief financial officer should provide the audit committee with analyst reports discussing the
accounting methods embodied in the company’s financials or criticising the “quality” of its earnings. Analysts are
quick to point out what they perceive as accounting gimmicks used by companies to improve their revenues or net
income. They typically try to get to a company’s core earnings by stripping away these gimmicks as well as nonrecurring
items, changes in tax rates and gains/losses from currency movements.

All these pieces of information should be sent to the audit committee at least one week before the committee
meets. During that week, the chairman of the audit committee should informally discuss with the auditor’s
engagement partner any specific issues raised by this information and more generally any “close calls” in the
financial reports.

If adopted, these measures will help audit committees identify the key judgments made by management and the
external auditors in preparing the company’s financial statements. Instead of trying to find a needle in a haystack,
committee members will be focusing on the accounting issues most likely to distort the accurate presentation of the
company’s financial situation.