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Weil, Gotshal & Manges LLP
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Mastering Corporate Governance, Part 2: When Earnings Management Becomes Cooking the Books - The Line Between Legitimate and Inappropriate Accounting Techniques Can Be a Blurry One, but the Audit Committee Must Endeavor to Make a Clear Distinction.
Millstein, Ira M.
(May 27, 2005, Finanical Times)
The polestar of the audit committee
is shifting - rather than focus exclusively on mechanics, structures and
controls (which are necessary but not sufficient), it is turning towards
the overriding policy issue, namely whether or not financial disclosure
presents a "true and fair" view of the company's state of affairs.
Faced with intense pressure to meet earnings estimates from analysts and
investors, executives at many companies use a variety of "earnings
management" techniques to help them "make the numbers".
These techniques will frequently exploit loopholes in generally accepted
accounting principles (GAAP) to manipulate deliberately the company's revenues.
"Earnings management"
includes both legitimate and less than legitimate efforts to smooth earnings
over accounting periods or to achieve a forecasted result. It is the responsibility
of the audit committee members to identify, by appropriate questioning
and their good faith judgment, whether particular earnings management techniques,
accounting estimates and other discretionary judgments are legitimate or
operate to obscure the true financial position of the company.
Examples of legitimate earnings
management efforts include postponing an acquisition or a disposal of assets
or other transaction until a later period, or otherwise accelerating expenses
when earnings are high and postponing expenses when earnings are low (for
example, by accelerating or deferring advertising expenditures in a quarter).
Others might include not replenishing inventories, or for financial organisations,
selling securities for a gain or loss during a period of high or low earnings.
As you get closer to the line between legitimate and less legitimate, some
companies opt for disclosure.
The line between appropriate earnings
management techniques and "cooking the books" can be a blurry
one, notwithstanding the plethora of detailed rules that are currently
in place to deter malfeasance. If audit committees fail to make this distinction,
further intrusive regulation could follow.
There will always be a temptation
to manage earnings inappropriately because meeting projections and "guidance"
suits everyone, from executives whose compensation may be based on earnings-driven
performance measures, to holders of options and Wall Street analysts. Earnings
management efforts require co- operation along reporting lines, and will
often involve boards and senior management at some level. Testifying in
the recent trial against Bernie Ebbers, former chief executive of WorldCom,
Scott D Sullivan, the company's former chief financial officer, admitted
that he "falsified the financial statements to meet analysts' expectations".
And as a lower-level former WorldCom employee, who was jailed for fraud,
observed: "When boards open the door a crack to unethical behaviour
. . . then it leaves a lot of interpretation for everyone down the line."
In this respect, it would seem that the title of Bob Garratt's 2003 book,
The Fish Rots from the Head, may be an accurate metaphor.
Regulators began paying serious
attention to the use of earnings management techniques in the 1990s, when
the market's short-term focus and the importance to management of increasing
the value of stock options and share prices swayed companies to use them
more widely. In 1998, at an address at New York University, the then- chairman
of the Securities and Exchange Commission, Arthur Levitt, spoke of the
emergence of a "grey area where the accounting is being perverted;
where managers are cutting corners; and where earnings reports reflect
the desires of management rather than the underlying financial performance
of the company." He referred to the following techniques, which were
being used by some companies inappropriately to manage earnings in response
to analyst and market pressure:
Deliberately overstating one-time
"big bath" restructuring charges to provide a cushion to satisfy
future Wall Street earnings estimates; Misusing acquisition accounting,
particularly improper write-offs of acquired in-process research and development,
to overstate future earnings inappropriately; Over-accruing charges for
items such as sales returns, loan losses or warranty costs when the company
is profitable and using those reserves to smooth future earnings when the
company is not so profitable - known as "cookie jar reserves";
Prematurely recognising revenue - for instance, before a sale is complete,
before a product is delivered to a customer or at a time when it is possible
that the customer may still terminate, void or delay the sale; Improperly
deferring expenses to improve reported results; And misusing the materiality
concept to mask inappropriate accounting treatment.
Mr Levitt asked the New York Stock
Exchange and the National Association of Securities Dealers to create a
committee to study intensively audit committee effectiveness in discharging
their oversight responsibilities and then make recommendations aimed at
improving US practices. I co-chaired the committee, along with John C Whitehead,
former Deputy Secretary of State and retired co-chairman and senior partner
of Goldman Sachs. We drew on previous studies and gathered input from regulators
and members of the business, accounting, legal and academic communities
to produce our February 1999 report entitled "Improving the Effectiveness
of Corporate Audit Committees."
The report focused on the reforms
that were needed to ensure "disclosure, transparency and accountability".
We recommended that generally accepted auditing standards require the outside
auditor to discuss with the audit committee the auditor's judgments about
the quality, not just the acceptability, of the company's accounting principles
as applied in its financial reporting.
The report also emphasised that
the discretionary nature of much financial accounting work means that there
cannot be a "one size fits all" solution to preventing accounting
irregularities. It encouraged each audit committee to think deeply about
its role and to develop its own guidelines to assist with supporting and
monitoring both responsible financial disclosure and active oversight.
The NYSE and the NASD embraced many of the suggestions set out in the report,
by mandating that they be included in audit committee charters. However,
those rules do not require audit committees specifically to think about
earnings management and the resultant ability to move financial disclosure
away from a true and fair representation of the state of the company.
Many of our recommendations were
beginning to be put in place before the Sarbanes-Oxley Act was enacted,
but private sector reform did not happen fast enough. Companies such as
Enron and WorldCom continued to engage in improper earnings management
techniques such as those outlined above, and worse. The private sector's
failure to adopt reforms voluntarily led to the bulk of our recommendations
eventually being enshrined in regulations, rules and practices by the SEC,
the NYSE, the NASD and prosecutors.
Broadly, NYSE and NASD listing
rules now require audit committees to adopt a formal written charter and
be comprised solely of "independent" and "financially literate"
directors, including at least one member with special expertise. In addition,
SEC regulations require the outside auditor to report to the audit committee
all critical accounting policies and practices that are to be used and
details of the alternative treatments of financial information within GAAP
that have been discussed with management.
SEC regulations also require the
audit committee to prepare a report for inclusion in the company's annual
proxy statement, outlining whether it has reviewed and discussed the audited
financial statements with management, discussed audit difficulties and
accounting adjustments with the outside auditors, and recommended to the
board that the audited financials be included in the annual report. Moreover,
professional standards set by the Public Company Accounting Oversight Board
require the outside auditor to discuss with the audit committee certaininformation relating to the auditor's judgments about the quality, not
just the acceptability, of the company's accounting policies.
The enactment of the Sarbanes-Oxley
Act, and section 404 in particular, has increased attention on process
and mechanics, such as internal controls and compliance with accounting
rules. However, this approach deals inadequately with the fact that questionable
earnings management can still occur within a sound network of internal
controls and within the boundaries of GAAP. Recent restatements by companies
such as Krispy Kreme, Nortel, Fannie Mae and SunTrust Bank, combined with
the increasing number of fraud-related enforcement actions, indicate that
accounting irregularities are still relatively commonplace. Pressure to
"make the numbers" is still being felt - for instance, the stock
prices of Amazon and eBay dropped 16 per cent and 19 per cent respectively
in recent months after the performance of those companies failed to match
forecasts.
Rather than focus exclusively on
process and mechanics, it is important to bring attention back to the substance
of financial reporting or risk even more regulation. The audit committee
has a key role to play in this process by focusing committee members on
looking beyond GAAP when evaluating discretionary judgments.
Guidance as to how to achieve this
may be gleaned from the approach taken in the UK. The United Kingdom's
Companies Act of 1985 requires directors to prepare accounts for each financial
year that give a "true and fair view of the state of affairs of the
company" (sections 226 and 227). Directors of listed companies must
also comply with the Combined Code requirement to "present a balanced
and understandable assessment of the company's position and prospects"
(Code provision D.1), or explain why compliance has not been achieved.
The annual report of a company
listed in the UK will include a statement signed by the board. This outlines
the responsibility of the directors to prepare accounts that give a true
and fair view of the state of the company, confirms that suitable accounting
policies have been used, and states that reasonable judgments and estimates
were made. The advantage of the UK model is that it squarely focuses board
attention on the integrity of financial reports, compared with the more
limited role of the management certification approach recently adopted
in the US under section 302 of the Sarbanes-Oxley Act.
Although useful, the UK approach
is not suitable for wholesale adoption in the US due to the differently
constituted nature of UK boards, which usually include many company managers
who are knowledgeable about the details. Moreover, as noted above, directors
in the UK are responsible for preparing the accounts, in contrast to the
US, where management prepares the accounts under the direction of the board.
However, a US audit committee could
achieve a similar result by requesting assurance from the outside auditor
that the report gives a true and fair view of the state of affairs of the
company, and that reasonable and prudent judgments and estimates have been
made, especially regarding revenue recognition, expenses and other items
that may involve earnings management. This will bring the focus back to
quality and fairness in substance, and beyond mechanics and structure.
Audit committee members can, in good faith, question the outside auditor
about discretionary judgments resolved in management's favour to effect
a better earnings picture both currently and looking forward, notwithstanding
compliance with GAAP.
The audit committee should encourage
the outside auditor to be candid and prepared to risk management displeasure.
Anecdotal evidence suggests that outside auditors, now directly employed
by the audit committee, are increasingly comfortable with challenging management.
For example in January, outside auditors at Eastman Kodak issued an "adverse
opinion" citing "material weaknesses" in the company's internal
financial controls for 2004.
This increased dialogue between
audit committees and outside auditors in the quest for quality financial
reporting should be the next major step in the long road of audit committee
improvement. Audit committees have been evolving in the US since the late
1930s and early 1940s, but did not emerge as a major feature of large corporations
until the 1970s, after financial manipulation led to the collapse of Penn
Central - then the largest railroad company and sixth-largest industrial
corporation in the US. An SEC investigation that followed the collapse
specifically criticised the outside directors' passivity and lack of financial
acumen, as well as the dearth of opportunities for outside directors to
engage in discussions among themselves. The investigation also revealed
widespread inappropriate financial reporting practices.
These shortcomings ushered in the
audit committee as a corporate mainstay. In a 1972 release, the SEC recommended
"the establishment by all publicly held companies of audit committees
composed of outside directors." Then, Stanley Sporkin, director of
enforcement at the SEC, began to insist that companies establish audit
committees comprised of outside directors as a condition to settling enforcement
proceedings.
In 1974, the SEC required issuers
to disclose in their proxy statements whether they had an audit committee
in place and, if so, to state the names of the committee members. Finally,
in 1977, the NYSE issued rules requiring all listed companies to establish
audit committees "comprised solely of directors independent of management
and free from any relationship that . . . would interfere with the exercise
of independent judgment." The NASD followed suit with rules requiring
Nasdaq-listed companies to establish audit committees comprised of a majority
of independent directors.
At this initial stage, outside
directors satisfied the then- prevailing definition of "independence,"
which was far less rigorous than the current standard. Since then, our
report, the NYSE and NASD listing rules, the Sarbanes- Oxley Act and SEC
regulations have further refined audit committee requirements.
The development of requirements
for independent audit committees in the UK and continental Europe has generally
lagged behind the US. In the UK, audit committees comprised of non-executives
were recommended in the 1992 Cadbury Report. This recommendation has since
become part of the Combined Code, according to which UK listed companies
are required to "comply or explain". In continental Europe, audit
committee requirements generally have not developed to the same extent,
although many European codes of best practice recommend that independent
audit committees be established.
The current wave of reforms in
the wake of recent scandals has necessitated audit committee members training
the bulk of their attention towards mechanics and structural improvements.
However, it is clear that technical compliance with GAAP is not, by itself,
enough to ensure quality and fairness in financial reporting.
Audit committee members should
now take a step back from the detail and refocus on ensuring that the substance
of financial reports is true and fair, and reflects the performance of
the company. To achieve this, audit committees should select outside auditors
with whom open and candid dialogue can take place in relation to earnings
management. Committee members should view the outside auditor as an information
resource so that inappropriate earnings management practices can be either
vetoed or ferreted out before the books become "cooked". This
approach should reverse the trend of restatements and corporate fraud,
and result in a higher degree of integrity associated with financial reporting.
If this happens, we may ward off even more regulation.
Ira Millstein is a senior partner
at the international law firm Weil, Gotshal & Manges and the Eugene
F Williams Jr visiting professor in competitive enterprise and strategy
at the Yale School of Management. He also serves as chairman of the private
sector advisory group to the Global Corporate Governance Forum founded
by the World Bank and the Organisation for Economic Co-operation and Development.
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