What you don’t know can’t hurt you.
That old adage may be true some of the time, but not for people serving on boards of directors and audit committees in the wake of recent scandals that have tarnished the reputation of corporate America.
If nothing else, the never ending page-one stories of accounting shenanigans have underscored how financial decisions – both the questionable and the downright illegal – can ruin a company. Moreover, board members who do not understand the increasingly complex financial transactions that companies engage in are placing their firms, and possibly themselves, in serious legal and financial jeopardy, according to faculty members at Wharton and the University of Chicago’s Graduate School of Business.
There is another, perhaps more subtle, message stemming from these scandals as well – that aggressive accounting, even the keeping of different “sets of books,” does not always constitute fraudulent behavior. Robert E. Mittelstaedt Jr., vice dean and director of Wharton Executive Education, says that the news media, shareholders, the public and even some board members do not realize that deciding what should go into a financial statement is typically anything but objective and clear cut.
“Rarely are there exact, agreed-upon numbers reflecting annual and/or quarterly revenue and profits,” Mittelstaedt says. “If you’re running the proverbial lemonade stand, it’s clear what you spent on supplies and what your revenues were. It’s a pure cash business. But if you are manufacturing capital goods like ships, airplanes or large computers and you design a new product, how much of that design cost do you amortize across the expected production over the next five or 10 years? The assumption you make about how many units you might sell affects how much you expense during any given period. If the sales environment changes, it may mean you have to change your financial statements.”
In the minds of most people, saying that a company is “keeping two sets of books” is merely another way of saying that the company is engaged in wrongdoing – that one set of ledgers represents the truth while the other represents creative legerdemain for shareholders or the IRS. Yet it is not uncommon at all for companies to juggle two or more sets of books at the same time, all of them valid but telling a different story.
“Companies always keep several sets of books,” says John Percival, adjunct professor of finance at Wharton. “To most people that sounds like companies are ‘cooking the books’, but most people don’t realize the limitations of trying to measure, in a scientific way, the outcomes we’re talking about here. GAAP [generally accepted accounting principles] tells you to keep records one way, tax law another way and regulators a third way. And sometimes, to be honest, you may keep even another entirely different set of books for internal purposes. It’s not that you’re trying to hide something, but you have to measure things in a way that accurately reflects [financial transactions]. None of this is well understood by business writers and it’s not well understood even by many managers.”
Roman L. Weil, professor of accounting at Chicago, is a stern critic of the lack of accounting and finance knowledge held by board members, especially members of audit committees. Weil also has been critical of CEOs who do not demand that some board members exhibit a willingness to learn more about finance and accounting. Weil says that he, in turn, has been criticized by chief executives for insisting that board members work to attain a certain level of financial expertise.
“People who have served on corporate boards have vision, wisdom, strategic insight, people skills and good decision-making skills, but they are not necessarily technically adept,” Weil says.
‘Technical Nerds’ vs. Marquee Players
CEOs, Weil adds, want other chief executives on their boards because of their experience and their name-recognition value. But he says most board members, even those who are accomplished executives, “are not interested and not trained to understand” important accounting issues. “The CEO says, ‘I don’t want a technical nerd on my board.’ I tell CEOs there are about 1,500 [unemployed] former Arthur Andersen people who understand these issues [and would love to serve on boards] but their names don’t have marquee value. I believe there are plenty of people who could do it.”
Arthur Andersen, which served as auditor for Enron, itself went out of business as part of the scandal that toppled the Texas energy company.
In Weil’s view, board members do not require the deep, technical expertise of accountants, but he says they should know more than they typically do.
“Here’s what I say all board members are responsible for: First, you need to understand business transactions that require that judgments be made. Second, you need to understand the accounting issues raised by transactions: ‘What is a cash-flow hedge? Is it an operating lease or a capital lease? How long is the asset going to last?’ Also, when management announces the judgments it has made about transactions, the board needs to understand the rejected alternatives. ‘What could management have done but didn’t do?’ I get a lot of pushback from corporate America saying that it is too much to ask. [My views] on the subject are not popular.”
New Rules for Corporate Governance
Audit committees have come under increased scrutiny in the aftermath of the accounting scandals involving companies like Enron, Tyco, Global Crossing and WorldCom. In 2002, a committee appointed by the New York Stock Exchange issued a report with a set of recommendations intended to improve corporate governance. Among other things, the NYSE said that members of audit committees should be independent and financially literate. It also said that the chair of an audit committee “must have accounting or related financial management expertise.”
“While it is not the audit committee’s responsibility to certify the company’s financial statements or to guarantee the auditor’s report, the committee stands at the crucial intersection of management, independent auditors, internal auditors and the board of directors,” the NYSE report said. It went on: “Because of the audit committee’s demanding role and responsibilities, and the time commitment attendant to committee membership, we urge each perspective audit committee member to evaluate carefully the existing demands on his or her time before accepting this demanding assignment.”
The Sarbanes-Oxley Act of 2002, which was passed by Congress on the heels of the NYSE report, has cast an additional spotlight on boards and audit committees and the standards they should meet. As directed by Sarbanes-Oxley, the U.S. Securities and Exchange Commission in April 2003 adopted a rule requiring the nation’s stock exchanges to prohibit the listing of any security of a corporation that is not in compliance with the audit committee requirements mandated by Sarbanes-Oxley. These requirements relate to the independence of audit committee members, the committee’s responsibility to select and oversee its company’s independent accountant and procedures for handling complaints regarding corporate accounting practices.
But Sarbanes-Oxley does allow an audit committee member to retain the services of an “expert” who can offer advice on finance and accounting rules and concepts.
Weil says he often tells committee members: “’You don’t deserve to hold the job now given what you have in your head.’ But they say to me, ‘Under Sarbanes-Oxley I can hire someone.’ I say, ‘You must understand this as you go along. You have to understand why [a certain financial transaction] is OK.’”
“Suppose the audit committee sees there’s a transaction underway that’s so complicated they can’t understand it,” says Richard Rosett, a former dean of Chicago’s Graduate School of Business who has served on numerous boards. “That’s the point at which you need to get an expert to come in and look at what it’s all about and what the effects are … The standard has always been that members of a board have a right to rely on expert knowledge, either from management itself or an outside expert. That’s one reason why you have outside auditor.”
One requirement of Sarbanes-Oxley is especially stringent – beginning in 2004 every public company must report to the government whether its audit committee has at least one “financial expert” sitting on it.
“I’m reasonably knowledgeable, but I’m not going to be able to qualify under the Sarbanes-Oxley definition of ‘financial expert,’” says Mittelstaedt. “And most accounting professors wouldn’t qualify either because the regulations define a financial expert as someone who has been an auditor or a CFO or CEO of a public company of similar size and has had responsibility for signing off on financial statements. I’m sure there are a lot of boards looking hard at their audit committee members to see who will meet those qualifications.”
The faculty members say it is important for directors to become more knowledgeable about accounting and finance because it is not always easy to figure out whether a company is engaging in legitimate aggressive accounting or outright fraud. Along these lines, Mittelstaedt, Percival, Weil, Robert W. Holthausen and others are teaching a new Wharton Executive Education course titled “Finance, Audit and Risk Issues for Board Members.”
Poster Child for Fraud
Mittelstaedt calls WorldCom the “poster child for dishonest accounting.” Items that should have been treated as ordinary costs were treated as capital expenditures, he explains. This allowed the items to be charged off over a long period of time and it meant that on its current books WorldCom had one-fifth the expense of the items that it should have had. “Everyone agrees that this was clearly over the line. The company had to be able to say it booked those charges, but it made the company look more profitable than it really was.”
At Tyco, the situation was different. “Tyco for years was accused of using improper accounting as it related to some of its acquisitions,” says Mittelstaedt. “The reality was that some of Tyco’s problems were related to [former CEO Dennis Koslowski] stealing from them. What Tyco did in accounting for its acquisitions may have been extremely aggressive but may not have been illegal. Some of Tyco’s accounting issues remain to be resolved.”
As for Enron, Percival recalls how positive press coverage of the company during its go-go days helped lead shareholders – and perhaps even responsible, well-intentioned directors – to ignore potential warning signs of disaster. “Part of the problem was there was real complexity in the transactions that Enron entered into,” Percival says. “The popular press sang the praises of this company, saying it was innovative and aggressive and a model for what all companies should be. There’s a temptation on the part of board members who read this to [accept it at face value.]”
An Open Door to Auditors
Holthausen, professor of accounting and finance and management at Wharton, says the general lessons to be learned from the various scandals is that “people high up in the organizations knew a lot about what they were doing and that they were, at a minimum, stretching the credibility of their financial statements. Some financial statements that were filed were within the parameters of GAAP and others were outside those parameters. But even when they were within the parameters, the companies worked hard to undermine the purpose of the principles.”
The scandals make it clear that audit committees need unfettered access to company accountants and auditors, according to Holthausen. “From a corporate governance point of view, the audit committee needs direct, intimate contact with auditors – not through senior management. The audit committee needs a direct line to accountants and to the internal audit staff. If you’ve got top management filtering access, the audit committee is not going to be able to do its job. People on the internal audit staff have to feel comfortable enough to call the audit committee at any time” if they need to discuss an issue.
If board members need to be persuaded of the benefits of brushing up on their finance and accounting knowledge, they do not have to go back as far as Enron and Tyco to get motivated. Consider some events of recent days. Three top executives at Freddie Mac resigned in June amid allegations of questionable accounting practices and the launch of a formal investigation by the Securities and Exchange Commission. At issue is whether Freddie Mac, a government-sponsored mortgage-finance company, made accounting decisions designed to “smooth out” its earnings. Freddie Mac said the SEC had been conducting an informal inquiry since January, when the company disclosed that it would restate financial results for 2000, 2001 and 2002. The restatements involved the way Freddie Mac accounted for complex financial instruments known as derivatives. Separately, the Office of Federal Housing Enterprise Oversight, which regulates Freddie Mac, is looking into accounting practices and possible employee misconduct at the lender.
Meanwhile, in an indictment unsealed on June 11, three former accountants at Dynegy, a Houston energy concern, were charged by a federal grand jury with fraud and conspiracy in connection with a series of transactions that boosted the company’s profits and cash flow in 2001.
On June 17, former Rite Aid CEO Martin L. Grass pleaded guilty in federal court to two counts of conspiracy in connection with an accounting scandal at the Harrisburg, Pa.-based drug-store chain, becoming the first former chief executive to plead guilty in a major accounting fraud case since Enron’s demise. On June 5, Franklyn M. Bergonzi, a former chief financial officer at Rite Aid, pleaded guilty to his role in the fraud. A third former executive at Rite Aid was awaiting trial. In 2000, Rite Aid restated its results for fiscal 1997, 1998 and 1999. The $1.6-billion restatement was, up to that point, the largest accounting revision ever in the United States.
In addition, a decision by a Delaware Chancery Court judge in a high-profile case involving Disney and its former president, Michael Ovitz, may be causing directors to sit up and take notice. According to a June 14 story in The New York Times, Judge William B. Chandler III ruled that a five-year-old shareholders’ lawsuit against Disney and its directors could proceed to trial. The suit alleges the directors had little say in Ovitz’ hiring in October 1995 or his departure little more than a year later when he left the company with $38 million in cash and options said to be worth $100 million. The judge said the allegations, if proven true, suggest that the directors were “consciously indifferent” to the terms of Ovitz’ contract – or as Chicago’s Weil puts it, “asleep.” The Times said the ruling is “the first to allow a case to stand against directors simply accused of failing to uphold their duties without any suggestion of self-dealing.”
The Bottom Line
The bottom line on all of these developments is that board members are “extremely worried,” says Holthausen. “All the scandals and the passage of the Sarbanes-Oxley Act have put additional pressures not only on boards as a whole but on audit committees in particular.”
It can be difficult, he adds, for even the most responsible board members to catch on if management and its accountants are intent on wrongdoing, which makes it essential to know as much about financial transactions as possible. “In some of the scandals there was out and out fraud going on. That’s going to be a really hard thing for anybody to catch, even an audit committee. If you’ve got people committing fraud, they can create a document trail that looks right. They know the tests that auditors do. They know the whole system of controls. I’m sure some of the companies where bad stuff happened had boards filled with cronies and others had boards who were diligent and who were floored when they found out what was going on.”
According to Percival, there should be “some minimum requirement for board members for reading a set of financial statements. The word ’reading’ is important. When you read a novel, there’s a bunch of words and grammar. But there’s also a story. It’s important not to get bogged down by the words. You have to grasp the story that’s being told.”