Lately, we’ve seen a number of high-profile cases in which publicly traded companies announce “accounting irregularities” (or some euphemism) that require the restatement of financial results. Sharply lower earnings forecasts, high-profile terminations of senior finance and nonfinance executives, and a collapse of the company’s stock price all follow in quick order.
Corporate damage can be long lasting. (Mercury Finance, Cendant, Waste Management, and Sunbeam are just a few examples of such casualties.) Restructuring to survive such a scandal may leave a company without strategically important businesses. Wholesale turnover of management may leave it vulnerable to takeover. And, without doubt, such an episode devastates morale throughout the ranks.
In the wake of these scandals, every corporate executive and every board member should be asking: “How can I prevent this from happening to my company?” But beyond soul-searching and the strengthening of corporate ethics statements, it is now crucial to reexamine the controls that are supposed to guard against accounting surprises. Companies should focus on two key mechanisms– the general auditor and the audit committee–to ensure they are independent and knowledgeable enough about finance to detect misdeeds.
The general auditor should be more than a mere policeman. When he or she describes the internal control program put in place to deal with corporate risks, the details should be plentiful and impressive. Chief executive officers and chief financial officers must know that the general auditor will not withhold any bad news–from shareholders or from the board. And board members should be encouraged to hold private discussions with this key executive. In the end, having a strong general auditor, who is comfortable in his relationship with the board and the CEO, is probably the greatest weapon in the fight against financial improprieties.
A strong audit committee is equally desirable. By installing committee members who have a working knowledge of finance, boards can be assured the right questions will be asked and clear signs of trouble recognized. Sophisticated watchdogs can ensure that red flags are raised, for example, when the company or a business unit consistently hits its targets in an industry that is weathering rough times; when inventories, accounts receivable, or intangibles are built up for unexplained reasons; or when an unusual turnover in the finance staff occurs.
To be most effective, however, these audit committee members must take a hard look at the business environment. I’m not suggesting that some businesses are inherently less ethical than others. However, some are necessarily more exposed to unscrupulous or “aggressive” accounting practices. One preventive action might be to ask the general auditor to prepare a report on past problems in the industry (or similar industries) so that management can watch for common danger signals.
The audit committee must also have a more-than- passing familiarity with the organizational environment. This includes knowing what formal and informal communications channels, staffing policies, reporting relationships, and reward systems exist. For example, committee members should understand to whom the business unit accounting managers report. If that person’s career is managed by his or her business unit leadership (rather than by the corporate CFO), there is greater risk that the employee will yield to pressure to make the numbers look good. Audit committee members should also ask: Are the business units highly independent or are they asked only to “deliver the numbers?” Do people, particularly finance people, routinely move across the business units, or do they spend their entire career in one unit? Are acquired businesses integrated into the parent company, or do they operate independently? Knowing the inner workings of a company will enable audit committee members to monitor potential troublespots more closely.
Fudging the numbers is not a new phenomenon, and it is unlikely to end soon. An audit committee, staffed by pros who know their business, may not be sufficient to prevent accounting fraud, but it is certainly necessary.