Testing the Financial Literacy and Expertise of Audit Committee Members

Article excerpt

In recent years, several laws and regulations have set new requirements for the financial literacy and expertise of members of audit committees. In 1999, the New York Stock Exchange (NYSE) added a rule requiring that each company have an audit committee comprising independent directors who are financially literate and including at least one financial expert. In that same year, the NYSE and the National Association of Securities Dealers (NASD) formed a Blue Ribbon Committee to make recommendations on improving the effectiveness of audit committees. Recommendation 3 of that report advocated the following:

[T]he NYSE and NASD [should] require listed companies with a market capitalization above $200 million ... to have an audit committee comprised of a trunirnum of three directors, each of whom is financially literate (as described in the section of this Report entided "Financial Literacy") or becomes financially literate within a reasonable period of time after his or her appointment to the audit committee, and further that at least one member of the audit committee have accounting or related financial management expertise.

Current NYSE (section 303A.06) and Nasdaq rules rely heavly on SEC Rule 10A-3(b), which sets required standards of independence, prohibiting an audit committee member from accepting directly or indirectly any consulting, advisory, or other compensatory fee from the issuer or any subsidiary under most cases. The NYSE Listed Company Manual section 303A.07 and Nasdaq Rule 4350(d) both include the three-member minimum and financial literacy requirements.

The Sarbanes-Oxley Act of 2002 (SOX) requires that each issuer of periodic reports to the SEC disclose "whether or not, and if not, the reasons therefor, the audit committee is comprised of at least 1 member who is a financial expert, as such term is defined by the Commission." Under SOX, expertise is measured by specific knowledge, experience, or a combination thereof. It has been suggested that non-accounting experts who fit the definition may be less competent to perform mis role tiian those with accounting-specific expertise (Gopal V. Krishnan and Gnanakumar Visvanadian, "Does the SOX Definition of an Accounting Expert Matter?" July 29, 2009, papers.ssrn.com/sol3/papers.cfm? abstract_id=866884).

Some recent attempts at measuring the financial (accounting) knowledge of current and prospective board members have been made in the studies of financial literacy cited below. With this background, the authors explored whether companies have formal processes in place for measuring or improving the financial literacy of audit committee members. The result is proposed content for testing financial literacy and financial expertise.

Financial Literacy

Current regulations and laws vary as to the meaning of financial literacy and financial expertise. Audit committee members are required to be able to read and understand fundamental financial statements under the rules of both the NYSE (Listed Company Manual section 303A.07) and Nasdaq (Rule 4350-4). Both regulations refer to SEC Regulation S-K [section 407(d)(5)] for the acceptance of a financial expert's qualifications.

The Blue Ribbon Committee did not define financial literacy but indicated that literacy includes the ability to read and understand fundamental financial statements, including a company's balance sheet, income statement, and cash flow statements. As Roman WeU. a professor at the University of Chicago observes, "It is clear they mean accounting literacy and not financial literacy." In their presentations to board members, Weil and his colleagues defined financial literacy by developing four criteria based on the "critical accounting policies and estimates" section of a company's Management's Discussion and Analysis (MD&A):

* Understand the transactions that require the judgments described.

* Understand the accounting and measurement issues for the policies and estimates. …