The Importance of Having a Financial Expert on the Audit Committee

Nicholas J Price

One of many issues that the financial crisis brought forth was that many board directors find financial reports to be too complex and confusing. The consequence of that is that board directors were approving financial statements they didn’t even understand. The problem of not having financial reports that are readable and easily understandable is that it makes it impossible for boards to fulfill their duties of financial oversight.

The Securities and Exchange Commission (SEC) decided that one of the ways to ensure that boards are equipped to produce and oversee corporate financial statements was to require publicly traded companies to have at least one financial expert on their audit committees.

To comply with laws and regulations, companies need to have a good understanding of who qualifies as a financial expert. Companies may draw a financial expert from their boards and committees or they may recruit and appoint someone new to fill the role. At the very least, the law requires boards to explain why they don’t have a financial expert.

Why Is It Important to Have a Financial Expert on the Audit Committee?

For public companies, the SEC requires them to have a financial expert, and they prefer it to be an independent board director.

Private companies aren’t required to have a financial expert on their audit committees. In fact, they’re not required to have audit committees at all. Despite the lack of the requirement, the National Association of Corporate Directors reports that 80% of private companies have an audit committee.

Audit committees are directly responsible for the appointment, compensation and oversight of the work of any registered public accounting firm that the company contracts with, as well as their own internal financial reports and disclosures. With such vital tasks at stake, it makes perfect sense that private companies would leave the responsibility to an expert rather than to chance.

Private companies that plan to take their company public will need a financial expert before their initial public offering. Getting a financial expert on board early places them a bit ahead of the game. In the interim, having a financial expert on the board protects the company from risk.

It’s probable that more accounting rules will be forthcoming. Companies that have a good financial expert will be in the loop on trends and developments and will be able to get up to speed on new laws and regulations quickly.

Who Qualifies as a Financial Expert?

The SEC passed rules to form a definition of who qualifies as a financial expert under Section 407 of the Sarbanes-Oxley Act. The final rules provide for a broader definition of an audit committee financial expert than a financial expert, which allows for a larger number of people to qualify as audit committee financial experts.

An audit committee financial expert must have all of the following qualifications:

  1. The expert must have an understanding of GAAP and financial statements.
  2. The expert must have the ability to assess the general application of principles in connection with the accounting for estimates, accruals and reserves.
  3. The expert must have experience in preparing, auditing, analyzing or evaluating financial statements that present the scope and complexity of accounting issues that are generally comparable to the complexity of issues that the registrant’s financial statements may raise or experience. The expert may have experience actively supervising one or more people engaged in those activities.
  4. The expert must be able to understand the internal controls and procedures for financial reporting and be able to understand audit committee functions.

To qualify as a bona fide financial expert, the audit committee financial expert must obtain their experience and education through one of the following positions:

  • Principal financial officer
  • Principal accounting officer
  • Controller
  • Public accountant
  • Auditor

In lieu of holding one of these positions, the expert may have experience in one or more positions where they performed similar functions. A qualified financial expert may also be someone who supervises a principal financial officer, principal accounting officer, controller, public accountant or auditor, or someone who performs similar functions.

What Are the Requirements Under the Exchange Act?

The Exchange Act requires specific disclosures about the audit committee financial expert.

Boards must disclose in their annual reports whether they have at least one audit committee financial expert. The Act requires boards to disclose the expert’s name and whether they’re independent or part of management. If a corporation doesn’t have an audit committee financial expert, they must disclose the reason in their annual report.

Experts who claim to qualify as an audit committee financial expert by reason of having other relevant experience must show a brief summary of their experience. Boards that disclose only having collective financial experience don’t qualify as having an audit committee financial expert under the regulations.

Section 11 of the Securities Act also clarifies the reach of liability that applies to audit committee financial experts. The law contains a safe harbor provision that protects audit committee financial experts from certain liability concerns. Audit committee financial experts aren’t responsible for any duties, obligations or liabilities that are any greater than those of any other member of the audit committee.

As members rotate on and off the board and the audit committee, your board portal is the best tool to document who the audit committee expert or experts are and that the board disclosed their qualifications accurately.

The best approach to ensuring that the audit committee has a properly qualified expert is for boards to see if they already have a qualified financial expert on their audit committee or their board and identify whether they’re independent or part of the management team. Not finding such a person, boards should start the process of recruiting a qualified individual for the purpose.

Companies that don’t have an audit financial committee expert may opt to disclose applicable attributes of the audit committee that qualify under the definition of audit committee financial expert, along with their explanation of why they don’t have such an expert. They should also include a statement of whether they sought assistance from outside experts.

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Nicholas J. Price
Nicholas J. Price is a former Manager at Diligent. He has worked extensively in the governance space, particularly on the key governance technologies that can support leadership with the visibility, data and operating capabilities for more effective decision-making.