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May 26, 2005 5:24 pm

When earnings management becomes cooking the books

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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 certain information 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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