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In what was only the latest in a continuing crackdown on improperly aggressive accounting, on July 18, 2001, the Securities Exchange Committee announced it had obtained settlements from American Bank Note Corporation (ABN), one of its subsidiaries, one of its customers, and executives from all three. In an attempt to meet aggressive earnings goals, at the end of a quarter, ABN executives arranged to ship product that was unfinished. They then booked the sales as revenues - a classic "ship and hold" transaction. In response to audit inquiry letters, the customer, by pre-arrangement with ABN management, confirmed the finality of the sales. In fact, the product was shipped back to ABN to be completed and shipped again in a subsequent quarter.
Civil Actions and Criminal Indictments
Culminating an investigation by the SEC and the U.S. Attorney for the Southern District of New York, various civil filings and criminal indictments were filed against entities and individuals. Many of the matters were settled at the time the actions were filed. In the settlements, corporate and individual defendants variously agreed to criminal guilt, civil injunctions, monetary fines, and prohibitions from serving as officers or directors of public companies and practicing before the SEC. This action brings corporate accounting practices sharply into focus, again.
Accounting Focus no Surprise
In the SEC's "Current Issues and Rulemaking Projects" June 21, 1999, release one of the accounting issues highlighted was "Initiatives to address earnings management." Earnings management and concealment of underperforming lines of business have been the subject of numerous speeches by SEC commissioners and staff and of a number of widely publicized actions taken by the SEC against public companies with household names, including Sony and Xerox. The ABN matter is only one of the latest to hit the financial press.
Focus on Independent Auditors
In a speech on November 5, 1999, at the 10th Annual Conference on Financial Reporting, Lynn Turner, chief accountant of the SEC, praised the marvels of technology and applauded the vast amounts of financial information readily available to millions of investors. He noted that this level of visibility created tremendous pressures to meet forecasts. He was strongly critical of those who try to meet forecasts by the "numbers game" - using various accounting devices to manage earnings. His call was for greater professionalism on the part of independent auditors, including personal accountability of those conducting the audits.
The accounting profession has by and large taken important steps to discharge what the U.S. Supreme Court called the "public watchdog" function of independent auditors. It may be companies and their boards that are lagging.
Focus on Boards of Directors
Independent auditors can only perform successfully if the material they are provided is truthful. In the ABN case, no fault was found with the performance of the independent auditors. They asked all the right questions; the written answers they received were lies. Except for extraordinary and expensive "fraud audits," independent auditors can audit successfully only when the company's managers and customers answer audit questions truthfully.
Ultimate responsibility for the corporate culture lies with a company's executive management and directors. Executive management is accountable to the board of directors. The board is the institution clearly charged with responsibility for oversight. It may be the vital link in the "watchdog" chain.
Focus on Independent Directors
From an independent oversight point of view, it is unfortunate that the same senior officers responsible for providing information to the board and the independent auditor frequently also serve as the company's directors. In order for the board to exercise independence and meaningful oversight, it must have a significant component of independent directors - directors with no current or recent past employment, professional, consulting, or other relationship with the company that might interfere with the exercise of judgments independent from executive management.
Blue Ribbon Committee
A blue ribbon committee with representatives from stock exchanges and professional organizations was formed in 1998 to study and make recommendations about how to make audit committees more effective. It issued its report in July 1999. Its recommendations included requiring that audit committee members be independent, have a minimum number, and have high financial qualifications. It defined "independent" so as to assure no present conflict of interest that would interfere with independent judgment. The committee recommended, as a condition to New York Stock Exchange or Nasdaq listing, that listed companies have a minimum of three independent directors all of whom would be able to read and understand financial statements and at least one of whom would, by virtue of prior experience or training, have special expertise in finance and accounting.
NYSE and Nasdaq Take Action
Both the NYSE and Nasdaq have adopted listing standards that implement some or all of the committee's recommendations. The Nasdaq rules for National Market issuers were effective in 1999, with issuers having until June 2000 to adopt audit committee charters and until June 2001 to certify their compliance with audit committee membership, number, and qualification requirements.
The Pressure is On
Boards of directors and, particularly, audit committees are expected to require executive management to meet high standards for compliance with SEC and accounting rules. No director or audit committee member can afford to accept what management provides at face value.
Directors have always been required to exercise their responsibilities with care and loyalty. It is a short step to find that directors who are audit committee members have, in addition to their normal directors' duties, a duty to work actively to assure the company's SEC reports are accurate and filed on a timely basis. This means audit committee members have to be vigilant, thoughtful, and energetic in discharging their responsibilities.
An Action Plan
Under the laws of California, Delaware, and most states, directors who are not
on the audit committee are allowed to make decisions in reliance on audit committee
reports, but only if reliance is justified under the circumstances. This means
that directors who are not on the committee have a duty to satisfy themselves
through their own diligence that the audit committee has the right tools to do
its job and is doing it. Directors should consider whether the audit committee
charter is broad enough for the task and whether the committee members have the
experience and independence to be the watchdogs of the board. Members of audit
committees should:
- Insist on authority broad
enough to carry out their responsibilities.
- Establish an internal
audit function reporting directly to the board as soon as the size of the company
warrants the expense.
- When there is an internal
audit function, assure that its personnel have necessary access to people and
files, that it is adequately staffed and supported, and that it reports directly
to the audit committee.
- Be prepared to take the
time required to understand the company's financial statements and SEC reports
and the company-specific accounting issues.
- Meet periodically with
independent auditors to review financial statement issues, SEC reports, and design
audit plans so that any "earnings management" activities and other accounting
or reporting problems will come to light before they become a problem.
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