Test your financial literacy: Financial literacy involves recognizing terms and understanding the implications of basic financial decisions. Here is one gauge of whether you make the grade.

AuthorLivingston, Philip B.
PositionFinancial Reporting

ARE YOU financially literate? If you sit on a public company board's audit committee, your answer had better be yes.

Responding to the recommendations of a "Blue Ribbon Panel" appointed by the SEC, in June 2001 the three major stock exchanges imposed new requirements on their listed companies for audit committee membership. In the broadest of the three rules, the NYSE requires each member of the audit committee to be "financially literate" and at least one member to have accounting or related financial management "expertise."

The NASD and AMEX go a bit further, requiring that audit committee members be "able to read and understand fundamental financial statements including a company's balance sheet, income statement, and cash flow statement." The two exchanges' rules further state that "at least one member [must] have employment experience in finance or accounting, requisite professional certification in accounting, or any other comparable experience or background which results in the individual's financial sophistication, including being or having been a chief executive officer, chief financial officer or other senior officer with financial oversight responsibilities."

Financial literacy, which involves recognizing terms and understanding the implications of basic financial decisions, can be acquired through education both formal or self-guided. (The accompanying test on financial literacy will let you know if you make the grade. Consider 11 correct answers a passing grade.)

Financial expertise goes broader and deeper than financial literacy and can only be acquired through the combination of education and practice, credentials and "in-the-trenches" experience. The financial expert on the audit committee should be able to ask the tough questions about financial reporting and recognize the warning signals of excessive risk, managed earnings and aggressive accounting. This person must be able to determine -- and to assure shareholders -- if the company is presenting its operating results in fair and transparent manner to its shareholders.

My organization, Financial Executives International (FEI), outlined three criteria for financial expertise. First is an understanding of Generally Accepted Accounting Principles (GAAP). Even though it's generally the external auditor's job to make sure a company's financial statements conform to GAAP, an audit committee member should have a working knowledge of the principles.

Second, financial expertise requires experience in preparing or auditing the financial statements of a company of similar size, scope, and complexity to the one on whose audit committee he or she would like to serve. This background assures familiarity with issues related to estimates, accruals, and reserve provisions as well as the underpinnings of a healthy internal control environment.

Finally, a financial expert should have spent some time sitting on one side of the table at an audit committee meeting, either as a member, a senior executive reporting to the audit committee, or an external auditor. This type of experience affords a sense of issues addressed by an audit committee and of how a responsible committee should function.

A person who has had a successful run as a CFO, particularly at a public company, should qualify as a financial expert and qualified audit committee member. I'm not suggesting this person should serve on the audit committee of his or her own company: The 1999 Blue Ribbon Panel also reiterated that audit...

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