Strengthening the Audit Committee
Written by C. Meyrick Payne of Management Practice Inc. with the assistance of Joseph Fleming and Garry Moody   

The purpose of this MPI Bulletin is to provide mutual fund directors with some practical guidelines as to their responsibilities and authority for strengthening the Audit Committee.

Truth is that Audit Committee members are under increasing scrutiny. The quality of financial reports is at stake. Uniquely in mutual funds, the Fund's financial staff and systems directly determine the price at which investors buy and sell their mutual fund shares, the net asset value or NAV. Mistakes, deliberate or inadvertent, cause some investors to lose money and opens the gates to expensive lawsuits and substantial damages.

Numerous regulatory and professional bodies are vitally interested in Audit Committee structure and procedures.

  • The SEC constantly emphasizes the responsibility of Audit Committees - for example for public corporations, which includes closed end mutual funds, the SEC now requires that the Audit Committee charter is published in the annual proxy together with an assurance from the Audit Committee members by name that the charter has been followed. The SEC has also proposed additional clarification as to the factors that need to be disclosed to the Audit Committee for them to assess the independence of the external audit firm.

  • The ICI has adopted as a "best practice" that the Audit Committee should (a) be made up exclusively of independent directors, (b) meet outside the presence of Fund management at least annually, (c) obtain annual representation that the audit firm is truly independent and (d) have a written charter to spell out its duties and powers.

  • The New York, American and NASD Stock Exchanges require that companies and funds quoted on their exchanges have an Audit Committee made up of no less than three independent directors, who are "financially literate". The SEC has extended that requirement to specify that at least one member has "accounting or related financial experience". While this requirement does not specifically include open-end mutual funds, it does raise the standard that fund investors expect. Some of the Panel participants found that this expectation caused certain Audit Committee members to step aside while former CPAs and/or financial executives or investment bankers are added to the Audit Committee

To establish an effective Audit Committee and the processes that make it efficient, the Panel believes that mutual fund boards should explicitly face and overcome the nine challenges. For each challenge the panel proposed certain proactive action steps. All of these challenges and plans are universal, confronting large and small funds alike. Of course the action plan may be more modest in scope for the smaller funds but the dilemmas are just the same.

This MPI Bulletin is intended to provide general business oriented suggestions; it is neither legal nor accounting advice, which should be obtained only from qualified counsel or accountants.

Challenge #1 - Stake Out the Audit Committee's Authority

Obtaining agreement as to the role of the Audit Committee with the full board, the fund management company and the external auditors is a crucial first step in the process. The Panel suggests the following action plan.

Action Plan - Define the Scope

The Audit Committee typically makes recommendations regarding the selection of independent auditors of the funds, confers with the independent auditors regarding the funds' financial statements, the results of audits and related matters, and performs such other tasks as the full board of Trustees or Directors deems necessary. The Audit Committee has special responsibility to review any potential conflict of interest that might arise in the management or oversight of the fund's investments or operation. These additional functions may vary considerably from fund complex to complex and may include seeking additional candidates for the Board, the oversight of investment policies, the daily pricing of fund investments, the oversight of brokerage allocation, the renewal and terms of the management contracts, and the compensation and governance matters of the board. However, oversight of investment matters and contract renewal frequently rest with separate committees.

Action Plan - Have a Written Charter

The Panel believes that the best way to stake out the authority of the Audit Committee is to have a written charter that is specifically agreed to by Fund management and the Board. This defines what is to be done and how it is to be accomplished. It also provides a written record of appropriate care and attention by the Audit Committee members should a law suit ever occur. Of course, an audit charter is also the single most damaging piece of evidence if it has not been diligently followed. Reproduced in Exhibit 1 is an excerpt from a real live Audit Committee charter that should provide some specific guidance.

Action Plan - Negotiate the Audit Fee

A very effective way to ensure that the external auditor remains accountable to the Audit Committee and does not inadvertently become too close to the fund manager is for the Audit Committee to explicitly negotiate the audit fee for each fund and in the aggregate. Of course the Audit Committee will need to involve management in this decision but the Panel agreed that it should specifically retain actual contract authority.

Sample Audit Committee Charter
Duties of the Fund Board Audit Committee

The Board to has appointed the Audit Committee to:

  1. Oversee financial reporting
  2. Provide the independent auditors and fund financial management with a forum for communicating directly with the independent directors of the fund
  3. Increase confidence in and objectivity of the fund's published financial reports

The Audit Committee will perform the following duties to fulfill these responsibilities:

  • Review and accept (a) the audit plan including the engagement letter, the scope of the audit, the audit procedures to be followed, the extent to which reliance on other auditors will be used, the process for resolving problems, if any, between independent auditors and Fund management, statutory accounting policy changes, if any, affecting the funds; (b) the independent auditor's Report on Internal Controls, including any comments or recommendations as well the Fund financial management's response; (c) the results of other audits conducted under SAS#70 of other financial service providers, such as transfer agent, custodian, bank or fund accountant; (d) the financial reporting process to ensure the adequacy of published statements of the Fund; (e) the process for monitoring compliance with tax and regulatory requirements; (f) fees paid to the fund auditors and other service providers.
  • Recommend the selection of independent auditors for the Fund or Funds.
  • Monitor performance, costs and fees and recommend any changes in the Administrative or Advisory contract between the manger and the Fund.
  • Monitor and recommend any changes to the Transfer Agency contract, especially when the service provider is affiliated with the Fund manager.
  • Hold private discussions with the independent auditors concerning their relationship with the Fund manager.
    Perform other such functions as the Audit Committee or Board may request, such as Director compensation and adequacy of Director and Officers Insurance.

Action Plan - Avoid Overreaching

The danger for an Audit Committee, which often serves as a catchall for all Board business requiring the involvement of the independent directors, is that it inadvertently becomes the Executive Committee of the Board. While this may not be undesirable, the full Board should recognize that directors who are not on the Audit Committee might feel left out. All Audit Committee problems are also problems for the full Board. As a result all Board members are entrusting a substantial part of their responsibilities to the Audit Committee.

At the other end of the responsibility spectrum, the Audit Committee might inadvertently assume managerial responsibility for operational activities. Differentiating audit oversight from management is an ever-present and important topic for Audit Committee members.

Challenge #2 - Attract, Retain and Motivate Audit Committee Members

The Audit Committee is a challenging assignment. It usually requires at least two meetings annually in addition to an already busy Fund Board calendar. In larger complexes the Audit Committee may meet as many as six times per year depending on the specific functions delegated by the full Board. The challenge is to attract, retain and motivate Audit Committee members.

Action Plan - Select Members with Appropriate Experience

Because the Audit Committee requires specialized expertise, there is a tendency for the chair to be held by an independent director with an accounting or financial background. This may be broadly defined to include investment banking but is more likely to be someone who was a CFO or corporate treasurer in his or her primary career.

Action Plan - Compensate for the Additional Effort

Generally an Audit Committee member is paid extra compensation to reflect the extra time expended for committee meetings. In the most recent Management Practice Inc. director compensation survey, the median additional compensation for an Audit Committee member is $4,000. Needless to say, there is a wide range, with some Audit Committee members receiving only an additional meeting fee while others receive a substantial retainer in addition to the meeting fee.

Occasionally the Audit Committee Chair receives an extra fee for organizing and setting the Audit Committee agenda. This can range from $2,000 per year to many thousands, especially where the Audit Committee chair serves as the defacto lead director of the full board.

Action Plan - Rotate Membership and Chair

To assist the Audit Committee to be innovative and fresh, many Audit Committees rotate the Chair every three to four years. Under SEC guidelines the audit partner of the external audit firm must rotate every seven years at a minimum.

Challenge #3 - Select and Oversee the Right Audit Firm for Your Fund

The most critical decision an Audit Committee has to make is selecting and managing the right external audit firm for your fund and complex. The challenge is how best to do this.

Action Plan - Retain Two Audit Firms

The Panel generally believed that a large complex, with over say 40 funds should have two firms auditing approximately the same number of funds. The primary reason for this was that the Audit Committee should have ready access to two perspectives. Some on the Panel though that the Audit firm or firms should have no relationship with the fund manager or its parent company, if any. Others felt that arbitrary application of this rule might deprive a fund group of the best possible choice for fund auditor. Everyone on the Panel did agree that there had to a Chinese wall between the audit team assigned to the funds and to the management company.

Where there are two audit firms, it is not uncommon for them to share work papers on areas where each has to do audit work to satisfy themselves as to internal controls and financial accuracy. The benefit of such sharing is to reduce overall costs and speed up the audit procedure without compromising quality.

In addition, a fund auditor will often have to rely on the work of another auditor for assurance where a service provider such as a transfer agent or custodian has control over some part of the funds records. Such reliance has to be fully spelled out to the Audit Committee.

Because the external auditor of a mutual fund has to have very specialized knowledge, the expertise has clustered in the Big Five audit firms. All do excellent work, provide good service and the audit partner and personnel may be presumed to have technical capability. While the fees for auditing a fund vary according to the work involved, they are not widely different on a per hour basis. As a result the Audit Committee will usually choose an external auditor on the basis of availability, perceived independence and, of course, personal compatibility with the Audit Committee and fund financial staff. Another important factor is that the audit firm is able to assign the same staff each year so as to avoid constantly retraining field audit personnel.

Action Plan - Use a Matrix to Judge the Audit Fee

One Panel member has a matrix system to help the Audit Committee evaluate proposed audit fees. This same matrix may also be used to test the relative reasonableness of audit fees from fund to fund.

On one axis is shown a degree of difficulty group of factors, such as number of positions held in the fund, foreign complexity, number of shares classes and number of sub-advisors. On the other is a rating for each on a scale of 1 to 5 (Exhibit 2).

EXHIBIT 2

Matrix of Factors in Assessing Fund-by-Fund Audit Fees

Factor

Weighting

Fund A Rating

Fund B Rating
 # of Securities in Fund

20%

1

5

 Foreign Complexity

20%

1

4

 Asset Level

10%

2

3

 # of Share Classes

10%

3

4

Tax Complexity

5%

2

4

Investment Complexity

20%

2

4

 # of Sub-Advisors

15%

1

2

Total Index

100%

12

26

All of these ratings are added together and the resulting index compared to other funds in the same complex or audited by the same audit firm. In this way the Audit Committee can have retain control over the amount of fees and be assured that the amount charged is reasonable. In the example shown the Audit Committee would expect the audit fee for fund B to be more than twice that of fund A.

The Audit Committee must assess the reasonableness of the audit fee on a fund-by-fund basis. In addition, the aggregate amount should also be carefully scrutinized as there are economies of scale in auditing funds just as there are in managing them. As a rough benchmark, the audit fee will rarely be less than $20,000 per fund and may be as much as $100,000 for large, multi-class funds with multiple affiliated service providers. The directors are entitled to ask external auditors to accept reduced fees where appropriate, particularly if the manager has agreed to fee waivers or expense caps. The overriding consideration is fairness to the shareholders.

Action Plan - Assess the Independence of the Audit Firm

The independence of the external auditor is usually assured through an extensive prior disclosure to the Audit Committee. At a minimum the Panel expected the following facts to be disclosed:

  • The amount of audit and/or consulting fees earned by the audit firm from other funds within the complex and/or the amount of fess earned from the fund manger, its parent and affiliates.
  • The amount of investments held by any partner or employee of the audit firm directly or indirectly in funds or firms controlled by the Funds, it manager or affiliates. Once a firm is appointed auditor, its partners and personnel directly involved in the audit are precluded from ownership.
  • A description of the scope of services provided to other funds in the complex, the fund managers, parent company and affiliates. An Audit Committee might decide that the scope of services provided is sufficiently small that no conflict of interest exists.

Selecting and overseeing the right external audit firm is one of the most important challenges facing an Audit Committee.

Challenge #4 - Understand the Pressure Points for Short Term Results

A key part of the Audit Committee's job is to understand where the pressure points exist so that that the members can be on the lookout for financial irregularities which are most likely to occur. This is easiest to see in a regular corporation where inventory, receivables, deferred assets and liabilities can relatively easily be the source of financial irregularities. In a mutual fund where the manager is entrusted with other people's money, the pressure points are more complex. Here are some action plans to help with this challenge.

Action Plan - Think About Pressure Points

A mutual fund is by definition a pool of money belonging to unrelated investors, entrusted to another to manage. The directors represent these investors. The pressure points are most likely to be misallocated costs, improper allocation of assets including valuable IPO rights, brokerage commissions and proxy voting rights. In addition there is the ever-present drive for better fund performance. This may at times nudge the fund manager to greater risk than the shareholder expects; while he or she may welcome the additional return when it occurs, they will surely rebel when losses occur. The Audit Committee is one instrument by which the full Board ensures that the terms of the prospectus are observed.

Action Plan - Remember that Fiduciary Responsibility Rests with the Directors

Before the passage of the Investment Company Act of 1940, and in most European countries, the primary fiduciary responsibility rests with the fund manager, which acts much like a trust department of a bank. In US mutual funds, this heavy responsibility is primarily placed on the fund directors' shoulders. As the SEC is fond of saying, the directors serve to safeguard the interests of the shareholders. The Audit Committee represents the full board in this regard.

Challenge #5 - Oversee the Allocation of Marketing and Sales Costs Under 12(b)-1 Plans

The Audit Committee plays a lead role in assuring the Board that the Fund monies, which may be used for fund marketing and sales under plan 12(b)-1, are properly accounted for. The challenge is find a way to ensure that this rule is properly followed and that shareholder funds are not misused.

Action Plan - Have the Fund Manager Commit in Writing

The Audit Committee members will usually ask the manager for an analysis of marketing costs and an assurance that the aggregate 12(b) -1 fees have not been used for other purposes. As a practical matter, the marketing and distribution costs are nearly always considerably in excess of the 12(b)-1 fee collected, so that the responsibility is relatively easily discharged.

Action Plan - Be Sensitive to Illogical Distribution Fees

However, there are times when the Audit Committee is required to make some tricky judgment calls. For example, when a Fund has shrunk in asset size despite having a 12(b)-1 plan in place, or where the manager - with no waiving of the 12(b) -1 fee - has closed a Fund to new investors. In such cases the Audit Committee may decide to let the 12(b)-1 continue on the grounds that today's fee is actually paying for accumulated deficits in the past.

Action Plan - Be Fair to "B" and "C" Shares

The Audit Committee may also be involved in determining the fairness of allowing a 12(b)1 fee to continue forever on "B" shares. Such investors have elected to pay their equivalent of the sales load in installments rather than all up front like their "A" share brethren. At some point, usually between six and eight years, the "B" shareholder has paid the same aggregate amount as the "A" shareholder. The Audit Committee may be charged with completing this analysis and recommending what, if anything, the full Board should do about the conversion of "B" shares to "A".

Challenge #7 - Matching Internal Controls to Today's Financial Landscape

The challenge is increasingly complex. Fund groups are increasingly global in scope. Individual funds invest in a wide array of investments, some extremely complicated, some structured for a particular purpose; others to capitalize on differentials in worldwide interest rates and commodity futures.

At the same time, the technology used to process fund transactions is becoming ever more sophisticated. Indeed much of it may be outsourced; so that the Audit Committee has to rely on the work of auditors other than that of the fund itself. The SEC and other quasi-regulatory bodies, such as the NASD and the stock exchanges, set increasingly high standards. The markets themselves are ever more volatile. Throughout all of this, the plaintiffs' bar, as well as the SEC itself, is increasingly litigious. Furthermore, the Audit Committee often becomes responsible for compliance with anti-discrimination, work safety, retirement and personnel disputes. In other words, the Audit Committee is a busy place.

Action Plan - Monitor the Auditor's Review of Internal Controls

Annually, the external Auditor should prepare a letter to the Audit Committee that assesses the system of fund's internal controls. There is no way an Auditor can check every transaction, so they rely heavily on the system of checks and balances built in to the daily routine of managing a fund. As specialized service providers, some of whom may be affiliated with the manager, conduct much of the fund's daily business, the review of internal controls must also cover those systems and procedures.

Action Plan - Clear Every Exception Cited

While the Auditor's management letter is the best source of information about internal controls it is also the worst threat to a directors' pocketbook if it is ignored. Every weakness noted must be discussed, corrective action proposed and taken. In the event that the Audit Committee decides that a weakness noted by the Auditors is unimportant, the minutes must reflect the reasons why and that follow up checks made to see that systemic weaknesses have not harmed the fund investors.

Action Plan - Weaknesses in One Fund May Replicate in Another

Directors of one fund are usually directors of another within the same complex. A weakness in internal control in one fund will often be found in another. Since the Audit Committee will often retain two audit firms to audit different sets of funds, a weakness found by one should be investigated thoroughly by the other.

Action Plan - Correct Seemingly Simple Compliance Exceptions

Most frauds, and even material accounting errors, start simply, often with no deep-seated malice. Over time, the perpetrators of the simplest mistakes or omissions try to cover their tracks and small problems worsen. For this reason all internal control weakness and compliance exceptions must be probed and corrective action taken.

The SEC examinations are by design deep and often pursue seemingly minuscule topics. For SEC examiners even small deviations from established practice are cause for concern. Any exceptions brought to light in an SEC examination must be diligently pursued by the Audit Committee (often acting on behalf of the full Board) and corrective action taken.

Challenge #8 - Safeguard the Fund's Soft Assets

In addition to the Fund's financial assets, there are at least three soft assets which merit the Audit Committee's attention; soft dollars (including directed brokerage), proxy votes and custodial float. An action plan for each follows.

Action Plan - Auditing Soft Dollars

The SEC has placed a special emphasis on the independent director's role in reviewing brokerage allocation and the creation and use of soft dollars credits. While this topic is beyond the scope of this MPI Bulletin, the Audit Committee should ensure that a process exists to see that "best execution" is obtained, soft dollars are used for research and directed brokerage is used to benefit the fund. Included but sometimes overlooked is the actual audit of the soft dollar account, which is usually maintained off the official books of the fund.

Action Plan - Voting Proxies for the Fund's Benefit

The proxy votes that attach to the investments made by the fund are another off the books asset of the fund. As such the Audit Committee should ensure that a process exists for safeguarding them. Usually this means that the full board, or another committee, has established a guideline as to how these proxies are to be voted. Again the underlying motivation must be to use these assets for the benefit of the fund shareholders.

Action Plan - Capturing Balance Credits or Float

When new money comes into the fund, shareholders are paid out, new investments made or shares redeemed there is often a cash float. The interest on this properly is an asset of the fund. The Audit Committee should ensure that a fair process exists for the value of float to accrue to the benefit of the shareholders. Sometimes reducing the amount of the fee for custody expense accomplishes this.

Challenge #9 - Understand the Unique Characteristics of Closed End Funds

Since closed end funds are essentially publicly traded corporations, they are subject to exactly the same regulatory requirements. The Audit Committee has to follow different rules.

Action Plan - Follow SEC and Stock Exchange Requirements for Public Companies

Audit Committee members have to demonstrate financial literacy and, in at least one member, expertise in financial or accounting disciplines. The unique review requirements for financial statements on Audit Committees of closed end funds produce an awkward time pressure. The external audit requirements are not usually completed for 30 days from fiscal year end and the printed financial statements have to be filed with the SEC within 60 days. Of course they have to be printed and bound in a form suitable for shareholders within this time period. The time pressure for Audit Committees of closed end funds is that the financial statements have to be reviewed before they go to the printer.

Conclusion

The Audit Committee is one of the busiest places on a mutual fund board. Membership has numerous responsibilities and is entrusted by the full board to act with a high standard of care and attention. This MPI Bulletin has laid out nine challenges and over twenty action plans to help Audit Committees.