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Audit committees: Are they on top of fraud and corruption?

03.26.15

In recent years, the audit committee’s responsibilities have expanded significantly. Although the committee’s top priority continues to be overseeing financial reporting, both regulators and investors expect it to take a proactive role in a company’s corporate governance and risk management programs. In particular, the committee should actively monitor and evaluate the organization’s antifraud and anticorruption efforts.

Setting The Tone At The Top

Among other things, an audit committee should ensure that management is setting the right “tone at the top.” In other words, the company’s ethics and compliance programs should be up to date (particularly in light of the Foreign Corrupt Practices Act and other anticorruption laws), and the business should have an effective crisis-management plan to deal with major fraud or corruption allegations.

The committee should also verify that management conducts periodic risk assessments and that the company has appropriate controls and procedures in place to help mitigate fraud and corruption risks. Executive buy-in and participation is important to help prevent fraud and unethical practices.

Understanding Members’ Liability

As expectations placed on audit committees increase, so do concerns regarding potential liability of the audit committee members. Committee members may be vulnerable to lawsuits by investors for securities law violations, fraud, breach of fiduciary duty, and various other civil and criminal transgressions.

A recent lawsuit demonstrates that the SEC is serious about holding audit committee members accountable. In March 2014, the Commission filed a complaint in federal court against AgFeed Industries, Inc., an animal feed company that’s publicly traded in the United States and was based in China before merging with a U.S. company in 2010. The complaint charged the company and certain executives and directors — including the chair of its audit committee — with extensive accounting fraud.

The alleged fraud scheme was perpetrated by four executives in China, who used various methods to inflate the company’s revenues by nearly $240 million between 2008 and mid-2011 in order to meet financial targets and increase stock price. For example, the executives booked false hog sales, later reporting that the fake hogs had died. Moreover, they inflated the weights of actual hogs sold. They also kept two sets of books — a fake set provided to the company’s external auditors and an accurate “inside” set that was hidden from them.

Misleading Information Abounds

According to the SEC’s complaint, AgFeed’s U.S. management learned of the accounting fraud in early June 2011, but failed to adequately investigate the fraud or disclose it to investors. The SEC alleged that the company’s postmerger CFO and audit committee chair schemed to avoid or delay disclosure of the fraud while they were attempting to raise capital for expansion and acquisitions. The audit committee chair ignored a former director’s recommendation to hire professional investigators guided by outside counsel, instead “internalizing” the situation while the fraud continued.

The allegations regarding AgFeed’s audit committee chair and CFO indicate the SEC believes they misled the company’s outside auditor and caused the business to issue false and misleading press releases and SEC filings. According to Andrew J. Ceresney, director of the SEC’s Division of Enforcement, “This is a cautionary tale of what happens when an audit committee chair fails to perform his gatekeeper function in the face of massive red flags.”

Exercising Professional Skepticism

To fulfill their responsibilities and avoid personal liability, audit committee members need to be vigilant in looking for signs of fraud. They also should exercise professional skepticism regarding management’s assertions about financial reporting, and act quickly to investigate when confronted with significant red flags.

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