Financial Statement Fraud, Sarbanes-Oxley And Corporate Governance

Thursday, January 1, 2004 - 00:00

John Tonsick
Citigate Global Intelligence adn Security

A little more than two years ago, Enron opened the gates to what seemed like a flood of corporate scandal. The fallout was a flurry of new regulations and a renewed interest in the concept of corporate governance. While companies are slowly coming to grips with the task of regulatory compliance, addressing the larger issues of financial statement fraud and corporate governance seem more elusive.

Sarbanes-Oxley

Accounting meltdowns like those at Enron, WorldCom, and Global Crossing created the perception that executive fraud and deceptive accounting practices were widespread. The public outcry forced Congress and the President to enact the Sarbanes-Oxley Act, a sweeping piece of legislation, which has had a profound impact on publicly traded companies and those who deal with them. Briefly, Sarbanes-Oxley established a new regulatory structure for auditors, mandated tighter corporate controls and imposed new disclosure requirements. It also prescribed tough penalties for those who do not comply.

That seems like strong medicine and, in fact, it is. However, the legislation does not, and perhaps cannot, address the fundamental problems that prompted its enactment.

A Demand For Change

After the scandals, the public was demanding accountability from those who run corporations. Investors and other stakeholders seemed less willing to tolerate self-serving management and passive, uninvolved board members who simply rubber-stamped their decisions. Institutional investors, fund managers, labor unions and others began raising their voices about board composition, "poison-pill" take-over defenses, executive compensation and a host of other "touch-stone" issues. As the drumbeat for reforms continued, so did the scandals.

In the spring of 2003, yet another accounting blow-up emerged at one of the country's largest health care conglomerates, HealthSouth. With more than $2.5 billion in faked earnings, former Chief Executive Officer, Richard Scrushy, was charged with 85 federal counts, including conspiracy, securities fraud, mail fraud, wire fraud, and money laundering. He faces a maximum possible penalty of 650 years in prison and $36 million in fines. Additionally, the government is looking to seize several homes, a Rolls Royce, a Lamborghini, two airplanes, Picasso and Renoir paintings, jewelry and more.

In at least one case, Sarbanes-Oxley seems to be achieving its objective in establishing accountability. However, something seems to be missing. Wasn't the legislation supposed to prevent these kinds of things from happening? In truth, Sarbanes-Oxley can only achieve so much. To prevent financial statement fraud, we need to better understand why it occurs and address the underlying issue of corporate governance.

What Is Corporate Governance?

The topic of corporate governance has garnered a lot of public attention over the past couple of years so I thought I would check for an authoritative definition. I was surprised to discover no fewer than half a dozen meanings reflecting a variety of different viewpoints and interests. One definition described it as "company management techniques and processes in general, or the way a particular company is managed." Another talked about suppliers of finance getting a return on their investment and still another talked about the relationship of a company to society. As I tried to reconcile them all, it occurred to me that perhaps I and others were making too much of this.

I remembered a story I once heard about the great jazz legend Louie Armstrong. Allegedly, someone talking to Louie about his music asked, "What is jazz?" He responded by saying "If you have to ask, I can't tell you."

With a nod to those who might see it differently, I drew a connection with Louie's concept of jazz and my own ideas about corporate governance. While a consistent definition may be elusive, I think that intuitively we all know what corporate governance means. It is about board members and senior executives who behave ethically, understand and effectively manage risk, and demand accountability from themselves and others.

Corporate Governance

Over the past two years, many senior executives and board members who've been called upon to account for the failures of their companies, have responded by saying they were unaware of any improprieties, that they'd been misled by underlings or that the auditors had failed them. Those answers don't provide much in the way of explanation or satisfaction. More importantly, the answers demonstrate an utter failure of corporate governance.

Ethics

The board and executive management have a profound influence on the quality of corporate governance. It all starts with "setting the proper tone." In the very worst cases, board members and senior executives are active participants in unethical behavior and create a culture where it flourishes. One only needs to look at HealthSouth to see this phenomenon at work. In the process of recording more than $2.5 billion of fraudulent income, it is reported that CEO Richard Scrushy instructed senior managers to "fix the earnings," so they would match expectations on the street. Senior executives who participated in the scheme were referred to as "family members" and the books were cooked at "family meetings." Company executives are alleged to have enforced discipline among the "family members" through threats, intimidation and payoffs.

If the people at the top of an organization show ethical lapses and engage in or tolerate unethical behavior, it will quickly become the accepted standard throughout the organization. The board and executive management must make it clear that they will hold themselves and others to high ethical standards. A good way to accomplish that objective is to publish an ethics policy and come down hard on those who violate it; in short, you've got to "walk the talk."
Understanding And Managing Risk

A recent survey of board members revealed that most were uncomfortable with their own knowledge of the business risk their companies faced. Obviously, you can't manage risk if you don't understand it. However, based upon the survey results, many appear to be doing just that.

Each company faces risks and opportunities that are unique to it and to its industry. The ability to take advantage of opportunities and avoid unreasonable risks depends upon having a working knowledge of the company and the industry in which it competes. Obviously, it is difficult, if not impossible, to find that kind of knowledge and skill in one individual, but collectively it must be present. Every candidate for a board or senior management position must be considered based on his or her contribution to that collective knowledge. It requires a multi-disciplinary approach that should consider technical, legal, marketing and financial skills. Once assembled, the team must take the time to analyze and evaluate their risk on a regular basis. That means meeting frequently with people who are actually doing the work and having substantial discussions about the company's activities. In looking at some of the more spectacular failures of the last couple of years, it is apparent that senior executives and board members either didn't know, or didn't care to know, what was going on. For example, Enron's board minutes show that they rarely met for more than hour.

Accountability

If you've been following the trends in executive compensation, you know that it's common to see rich rewards for success. It is a lot less common to see board members and senior executives pay a price for poor performance. Being accountable means having some skin in the game, personally, professionally and financially. The stiff penalties established by Sarbanes-Oxley have increased the personal and financial risk, but they're not enough.

Board members should have a significant financial stake in the companies on whose boards they sit. Owning a large chunk of stock helps them to be attentive and skeptical. It is also a strong message to other stakeholders that the people making the decisions are taking the same risks that they are Ñ a comforting thought during difficult times. Additionally, board members and senior management need to be measured against realistic, verifiable standards. Those standards should include performance against peer groups and other outside measures, not just stock price or meeting earnings objectives.

Financial Statement Fraud

The financial statement frauds of the past two years resulted in the passage of the Sarbanes-Oxley Act and helped bring the subject of corporate governance to its current place of prominence. For that reason, I think it is appropriate to discuss one more topic of tremendous importance: the reasons financial statement fraud occurs.

Fraud cannot occur without the presence of three essential elements: 1) need; 2) opportunity; and 3) the ability to rationalize. Financial statement fraud is no different, except that the perpetrators are usually senior executives. Statistics show that nearly 80% of financial statement fraud involves the CEO and/or the CFO. This is so because their positions within the company provide them with the greatest opportunity. With a sufficient amount of pressure, human nature provides us all with the ability to rationalize bad behavior. Having satisfied reasons 2 and 3, I will focus my attention on need.

During the past decade, executive compensation has skyrocketed. In the year 2000, the average CEO made 500 times more than the average factory employee did. With compensation tied to stock prices and earnings targets, personal gain has provided a huge incentive to commit fraud. Public attention has caused some slowing in this trend, but executive compensation in many cases is still way out of line.

A more complicated task is dealing with the pressure created by the marketplace. The stock market pummels companies who miss projected earnings targets, even when the shortfalls are insignificant compared to other measures. Those who run public companies are under tremendous pressure to perform and often feel that failure is unforgivable. That pressure can create an overwhelming incentive to cook the books. To remedy this problem, investors need to be more tolerant. Creating that kind of environment will require some creative thinking on the part of many.

John Tonsick is a Managing Director at Citigate Global Intelligence and Security in Los Angeles. He is a CPA and Certified Financial Examiner. Questions can be directed to him at (213) 716-0667.