Thursday, February 10, 2005

Governance, Sarbanes-Oxley And Value Reporting:

Governance, Sarbanes-Oxley And Value Reporting:
New Life for the Shareholder? or, a "Wink-and-a-Nod"

Ineffective Board representation combined with 'transition' into grand scale absentee ownership (investors who are indifferent about the nature of their assets, as long as it produces the desired return) has produced an amnesia with regard to risks entailed with management self-dealing. The other participants in the recent financial crisis have been the legislators and lobbyists, which partly produced the reason for the Sarbanes-Oxley Act of 2002 ("SOX"). Again, we seem to have the same culprits of previous financial failures, as demonstrated in the 'unintended' consequences of most of the S&L legislation. With respect to the success of SOX, prudence exhorts skepticism; perhaps board and governance along with educated 'owners' and other stakeholders may remedy agency self-dealing.

Further, those knowledgeable of the legislative process, as well as the forces that drive matters to the point where legislation becomes the result are asking was the SOX really the right answer? With Congress' interest to legislate corporate governance, accountability for internal controls, and firms which provide that and external reporting services, was SOX necessary federal legislation when the SEC could have had the Exchanges require any eventual compliance of its listed firms? Was it necessary to make into statute the practice of arm's length assurance and audit? Perhaps the 50 states should audit the companies incorporated in each one, looking for signs of malfeasance and negligence, rather than permit further federal encroachment into states' matters. I remain somewhat skeptical that more vigilant oversight wouldn't have been the appropriate answer at the board level of the issuers, at the accounting firms, and for their profession's code of conduct to remain fully respectful for the degree of integrity necessary to provide such services that fan the public trust, or cynicism and litigation. Perhaps without federal force, however, nothing would have changed, even though we should be concerned about what REALLY changed below the radar screen, and SOX's "unintended" consequences.

Congress hoped to subtly shed attention, and thus, blame from itself and its campaign contributing management and board cronies. With Congress typically passing management-cozy laws, in SOX however, the jury may be out still on management's continuation of its recent practice of battering the reporting model in order to self-deal and self-enrich. Between senior management certifications required under Sections 302 and 906, and discipline for improper influence on conduct of audits in section 303, management, auditors, and external reporting firms may find it extremely difficult to commit fraud and misrepresent the firm's performance. The Act is attempting to end to corporate earnings-gaming by requiring 'arms-length' practices for the reporting and earnings calculating via disciplining and diminishing the relationship between management and the public accounting firms. Additionally, SOX is repositioning a firm's relationship with the public accounting firms at the board level. In several other sections including Section 404, SOX also shifts internal audit responsibilities toward oversight of financial integrity, hopefully including a greater emphasis on the quality of the information produced from the internal reporting with associated controls, not merely auditing the systems to determine levels of functionality, which was formerly what the internal audit largely examined. Section 804 extends the 'Statute of Limitations for Securities Fraud', hopefully another way to mitigate corporate fraud (all above and following SOX references are cited from E&Y's "Sarbanes-Oxley Act of 2002 The Current Landscape (Rule Updates and Business Trends", as of 8/03).

Firms enjoy access to the public exchanges, however, and while listed to trade publicly, they are required to comply with the new legislation. With SOX eliminating much of the former permissibility to use the reporting model to contort appearances of financial performance (Section 401 is requiring complete, enterprise wide disclosure, linking with the SEC's Reg G (1/22/03) to prohibit presentation of misleading and inaccurate non GAAP reporting), this may be why management is seeking desperately to retain the use of free options and is attempting to have Congress force the FASB to withdraw pending GAAP to expense options as a form of executive compensation.

Evidently, SOX likewise is producing 'pressure' at firms such as Ernst & Young, which we see: "Following the passage of the Act (SOX), these pressures continue to mount, together with increased regulation, and a renewed focus on corporate governance practices and financial reporting integrity and transparency", found in the opus of E&Y's Rule Updates and Business Trends, "Sarbanes-Oxley Act of 2002" (8/03), a helpful document E&Y provides to summarize the sections of SOX.
E&Y and its peers have every ability to produce quality audit and assurance services to prevent misrepresentation, fraud, and piracy of every sort in public reporting, if they remain committed to the task. One sees this admirably demonstrated in the "Company A Cash Disbursements - Narrative", 12/31/03 (Audit/Control) checks and balances at the cash disbursements level. Perhaps not having participated in official audits, I also found impressive E&Y's Assurance and Advisory Business Services "Preparing for Internal Control Reporting, A Guide for Management's Assessment under Section 404 of the Sarbanes-Oxley Act" (0677), "Evaluating Internal Controls" (in 3 parts), as a part of E&Y's services to provide "comprehensive assessment and documentation of the effectiveness of internal controls over financial reporting" pursuant to Section 404 (0677, p. 2). Perhaps the control and reporting staff at listed firms should be required to comply with Continuing Professional Education in control accounting and financial reporting including new GAAP; professionals at the public accounting firms must meet these continuing ed requirements (0677, p. 14, "Whether the accounting department has processes in place to identify significant changes in GAAP promulgated...").

Although it should not surprise me, notwithstanding, I found the distinction made between audit and assurance services rendered by the public accounting firms to listed companies where E&Y indicates, "Finally, the project team needs to include in its understanding and evaluation the company's process for producing financial reports" (0677, p. 21). Was this responsibility overlooked before SOX, and now must be part of the check list of assurance/audit firm tasks? Perhaps a disconnect existed between the respective results of audit and assurance efforts, where one may attribute the disconnect partly to a management disrespect for the "Cost-Benefit Concept" that would avoid reducing difficult-to-quantify risks and the practice of 'old-fashioned' audit tasks (0677, p. 27). Sadly, the accountants complied. Hopefully, with the SOX created PCAOB, the accounting firms will find that they need to render superior, arm's length work (Sections 101 & 102, 104, and 108). And meanwhile, 'window dressing' comes to mind. E&Y Partners Haverstick and Ridder mentioned that internal audit responsibilities are shifting more towards oversight of financial integrity (Sarbanes-Oxley Act of 2002: The Current Landscape, p. 5, Section 302: Management Certifications Business Trends). From what are these responsibilities shifting? What before was so flawed about how E&Y handled these things, and how can E&Y certify systems as fool-proof and game-proof? Time will tell.

Not fully agreeing with Eccles, et al's premise that the 'reporting model' has failed, I absolutely support complete transparency, high-idealed board practices, and corporate governance that are fully accountable to the non management shareholder in every prudent way in order to eliminate the pervasive agency problem that has been abusing the stakeholders in public companies. Further, internationalizing the reporting model adds yet another element of distraction that management uses to self-enrich and promotes corporate colonialism; we need to deal with our US GAAP problems. Eccles, et al, also had mentioned three dimensions of risk that companies should answer in their financial reporting: what has management practiced to produce 'value', what practices destroy value, and what confidence has the ordinary investor to estimate the distribution of outcomes (Eccles, et al, p.145, 146). Although the authors have asked in the end something seemingly abstract, perhaps investors unconsciously ask themselves this by their 'investment' choices, such as choosing mutual funds.

Perhaps few investors really care about SOX, however, and the aforementioned associated efforts that we are making regarding increasing transparency and more effective governance. Perhaps huckstering the 'markets' as a 'safe' investment and as a proxy for savings accounts, but now attracting the same market gambling that previously found outlet at the race track has contorted the activity in the investment markets, coincident with this get-rich-quick mentality that is occurring in times of indolence which also promotes corporate interests and self-dealings front and center stage. Such speaks ill of our society, when commercial interests have gained the power and attention that they have. SOX will not solve any of this.

The authors give us the following past-as-prologue concerns. First, the authors state that boards must demand the necessary information (Eccles, et al. P. 239). Should we assume the authors are telling us that boards of directors neglected to ask for full disclosure and full transparent financial reporting from management? Or rather, why wasn't management giving the board this information?

Next, perhaps Shareholders' Equity would provide the better location for reporting of changes in Goodwill, as these fair value changes fail the realizable and earned tests for income statement reporting (Eccles, et al, p. 241, 242). The authors also discuss internet measurement standards for intangible items that need valuation for balance sheet purposes, however, which I would never include in the Income Statement (p. 261), unless these items actually earned realizable revenue.

Eccles, et al, further believe that Value Reporting Revolution can eliminate information confusion that seems to be causing battles among the users and issuers of financial reports (p. 249), rather than exposing management's interest to self-enrich, which in realtiy is producing the confusion. The authors fail to observe another associated factor which is management's desire to distinguish itself from the next guy, so as to gain the investors' dollars. It seems this is partly the undertow to the authors' interests and thesis related to finding the 'value drivers' of firm, including the Global Reporting Initiative (triple bottom line). In addition, the accounting firms should include in their audit report their insights 'about how to improve that performance" (p. 267) and charge for it accordingly. The auditors' job is not to advise management, however, and here the authors reveal their continued co-dependence to have some management level, value-added position that violates the arm's length, disinterested 3rd party rule, and exists as another part of the undertow. The authors err again when they smugly add that the industry 'expert' model has worked well for management allies such as the bankers and consultants, and that the accountants likewise can enjoy this (p.269, 270).

Without omission about the role of sell-side analysts, a respected utility analyst by the name of Barry Spenser (God rest his soul) once noted about this group, "Why do you think they call it the SELL side?" His rhetorical comment answered many questions related to the problems everyone else had with Wall Street and sell-side analysts. The public had failed to ask Wall Street about the truthful role of the 'sell-side' analyst, and wait for the correct answer; salesmen will tell you anything if they are permitted.

Andrea Psoras
Franklin & Marshall College
Bus481 Financial Reporting
For April 1, 2004

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