Independence and Objectivity: Retired Partners on Audit Committees

Article excerpt

Retired audit firm partners represent an attractive pool of potential members for public company boards of directors and their audit committees. Because of the stock exchanges' new listing requirements, corporate boards are actively seeking retired partners as members. Before considering or making such appointments, however, the audit firm and the company must resolve a number of independence issues.

Exchange Requirements

In December 1999, The New York Stock Exchange (NYSE), National Association of Securities Dealers (NASD), and the American Stock Exchange (AMEX) adopted new listing requirements that all members of a company's audit committee must be (or on their way to becoming) financially literate, unless the company qualified as a small-business filer. In addition, at least one member of the committee must possess accounting or financial expertise. Although the meaning of financial literacy is vague and varies among the exchanges, the intent is for all audit committee members to have a general understanding of financial statements, including GAAP and a general knowledge of auditing. Because retired partners of audit firms fulfill the financial literacy requirements and bring many other valuable attributes to boards, they are prime candidates for corporate boards and their audit committees.

An historical note. The authors' research indicates that it was only in 1974 that Household Finance Corporation became the first U.S. public company to appoint a retired partner of an audit firm to its board. The appointment was very carefully and sensitively handled; the company asked Haskins & Sells, its external audit firm, if it would object to the new board member, Thomas D. Flynn, who was then retiring as a senior partner of Arthur Young & Company. Haskins & Sells interposed no objection, and the appointment went ahead. A more interesting question arises, however, when the newly appointed board member is a retired partner of the company's current external audit firm.

Conflict of interests. The financial collapse of HIH Insurance Limited was widely reported in the Australian press in 2001. Among the many issues raised by the incident was that two nonexecutive (i.e., outside) board members were retired senior partners of HIH's external audit firm. It also became known that both of these retired partners were members of the board's audit committee, and that one chaired it. The Australian government appointed a Royal Commission to investigate and report, and among the issues that the Prime Minister directed the commission to consider was whether the decisions or actions of HIH and its personnel "involved undesirable corporate governance practices."

The appointment of retired partners of a company's external audit firm to its board of directors brings up a number of questions about the independence and objectivity of the audit firm. When a retired partner of the company's external audit firm also sits on, or even chairs, the board's audit committee, serious questions about the committee's independence and objectivity may arise.

Appointing retired partners of a company's external audit firm to the company's board, and even to its audit committee, is not precluded by any rules and regulations in such countries as the United States, Canada, the United Kingdom, Australia, and New Zealand. In the United States, the practice would be allowed as long as there is no financial dependence, influence, or the appearance of continued association by the retired partners with their former audit firm. The practice of appointing retired partners of an audit firm to a client's board of directors occurs in all five of the above countries, but the extent to which it occurs is not readily known.

SEC Requirements

If a retired partner of an audit firm becomes a member of the board of directors of one of the firm's audit clients, he or she is thrust into an accounting or financial reporting oversight role, which triggers the application of the SEC's rule 2-01(c)(2)(iii), "Employment at Audit Client of Former Employee of Accounting Firm. …