Buffett (2002): The primary job of an Audit committee and the four questions the committee should ask auditors.

Buffet explained some key corporate governance policies in his 2002 letter to shareholders. After driving home his views on independent directors and their compensation, he has now turned his attention towards the audit committees that are present at every company.

Audit committees - Substance and not form

The primary job of an audit committee, says Buffett, is to make sure that the auditors divulge what they know. Hence, whenever reforms need to be introduced in this area, they have to be introduced keeping this aspect in mind. He was indeed alarmed by the growing number of accounting malpractices that happened with the firm's numbers. And he believed this would continue as long as auditors take the side of the CEO (Chief Executive Officer) or the CFO (Chief Financial Officer) and not the shareholders. Why not? So long as the auditor gets his fees and other assignments from the management, he is more likely to prepare a book that contains exactly what the management wants to read. Although a lot of the accounting jugglery may well be within the rule of the law, it nevertheless amounts to misleading investor. Hence, in order to stop such practices, it becomes important that the auditors be subject to major monetary penalties if they hide something from the minority shareholders behind the garb of accounting. And what better committee to monitor this than the audit committee itself! Buffett has also laid out four questions that the committee should ask auditors and the answers recorded and reported to shareholders. What are these four questions and what purpose will they serve? Let us find out.

The acid test
As per Buffett, these questions are -

1.  If the auditor were solely responsible for preparation of the company's financial statements, would they have in any way been prepared differently from the manner selected by management? This question should cover both material and nonmaterial differences. If the auditor would have done something differently, both management's argument and the auditor's response should be disclosed. The audit committee should then evaluate the facts.

2.  If the auditor were an investor, would he have received - in plain English - the information essential to his understanding the company's financial performance during the reporting period?

3.  Is the company following the same internal audit procedure that would be followed if the auditor himself were CEO? If not, what are the differences and why?

4.  Is the auditor aware of any actions - either accounting or operational - that have had the purpose and effect of moving revenues or expenses from one reporting period to another?

Toe the line or else...

Buffett goes on to add that these questions need to be asked in such a manner so that sufficient time is given to auditors and management to resolve any conflicts that arise as a result of these questions. Furthermore, he is also of the opinion that if a firm adopts these questions and makes it a rule to put them before auditors, the composition of the audit committee becomes irrelevant, an issue on which the maximum amount of time is unnecessarily spent. Finally, the purpose that these questions will serve is that it will force the auditors to officially endorse something that they would have otherwise given nod to behind the scenes. In other words, there is a strong chance that they resisting misdoings and give the true information to the shareholder.

 http://www.equitymaster.com/p-detail.asp?date=8/13/2008&story=1