Since Sarbanes-Oxley was enacted six years ago, financial reporting has improved and investor confidence followed suit. That doesn’t mean people are satisfied with the way things are going—or, indeed, whether they know which way they want things to go at all.
Such was the sentiment expressed by a panel of experts in Boston last week, convened as part of the Center for Audit Quality’s “National Public Dialogue Tour” hitting nine cities in the last year. The CAQ launched the tour to solicit input on how the auditing process can be improved and be more helpful to investors.
A main theme in last week’s session was how to strike the best balance between the principles-based standards everyone says they want in corporate governance, versus the clear but exacting rules-based system used today.
“I see a bit of a schizophrenia among the corporate profession,” said Robert Pozen, a speaker at the discussion and chairman of MFS Investment Management. (Pozen also chairs the Securities and Exchange Commission’s Committee to Improve Financial Reporting.) “On the one hand, people want principles. On the other hand, when you get into a specific subject, people say, ‘Well, how would you treat this example? This is ambiguous.’”
For example, he said, many people fault the Federal Accounting Standards Board for issuing volumes of rules, interpretations, and other guidance. But much of that has to do with “lots of companies and lots of auditors” asking for solutions, Pozen said.
John Mahoney, CFO and vice chairman of Staples and another speaker at the event, agreed. Financial reporting and auditing have become so complex that “when a new rule comes out, if it’s principles based, a user or a preparer of a financial statement doesn’t really know the context in which to prepare those financial statements,” he said.
Revising financial statements was another main topic of discussion. Restatements have soared in the last decade; many critics of regulation cite this growth as prime evidence that rules have become too complex and intimidate companies into formal restatements more often than is really necessary.
“I think there is certainly room for improvement in terms of looking at whether something is material to an investor,” said James Kroeker, deputy chief accountant for the SEC.
Pozen said that historically, companies only made restatements when some dire error was discovered in the financials. Now, he contended, making a restatement has lost its stigma and companies make them for all manner of offenses. “The question is,” said Pozen, “Do you need to have a restatement for every material error?”
A study released April 9 by the Treasury Department stressed that point. It found that restatements jumped from 90 in 1997 to 1,577 in 2006. (Most of that increase came from small companies not traded on major stock exchanges, the report noted.)
The data also revealed that restatements by larger companies often involved fraud, revenue recognition, or complex accounting issues such as derivatives and foreign subsidiaries. In contrast, restatements at smaller companies mostly reflected problems with ongoing operating expenses, stock-based compensation, and debt.
The Treasury Department commissioned the report in May 2007 as part of Secretary Henry Paulson’s search for ways to make U.S. financial markets more competitive. But whether those findings are still valid is subject to question. As Compliance Week has previously reported, restatements fell in 2007—the first outright decline this decade—by 31 percent. And companies complying with Section 404 of Sarbanes-Oxley have seen restatements drop for two consecutive years.
Often, Kroeker said, companies choose to issue a restatement for fear of being second-guessed by a regulator, rather than focusing on those issues that are important to a reasonable investor.
“One of the really important points to remember is that investors really don’t care about the past. Past results are not necessarily indicative of future performance.”
— John Mahoney,
Pozen noted that investors have their own grievances about the restatement process: Often when a company announces a restatement, it will go a year or longer without releasing any new information, until it cleans up the mess. He suggested that companies with relatively minor problems could simply publish a Form 8-K to correct the numbers and move on, rather than spend more time figuring out every detail.
Another point of confusion is exactly how much investors should (or should not) rely on financial statements to set their expectations for future results. While the SEC is trying to get companies to be more forward-looking, Pozen said, by asking the financial statements to look into the future, “we are really asking the financial statements to do something that they can’t do very well.”
Mahoney echoed that sentiment. “One of the really important points to remember is that investors really don’t care about the past,” he said. “Past results are not necessarily indicative of future performance.” Most professional analysts, rather, are interested in things “outside the scope of the company’s historical performance,” such as assessing the market competition, he added.
The panelists also stressed that a financial statement is really only a framework to give investors a sense of the company’s overall financial operations. “You cannot convey in a single statement everything an investor needs to know,” Kroeker said. He gave the example of off-balance-sheet instruments; at a gut level investors know such instruments often mean trouble, but fully understanding a company’s use of such devices “is going to take more than looking at a number in the balance sheet,” such as poring over the footnotes.
Pozen added that he favors finding some way to divide statements so that they show investors what a company’s core earnings are, versus what earnings fluctuate. Such an approach would satisfy both the desire by analysts to flush out fluctuating earnings and the desire by CFOs to diminish volatile earnings, he said.
Individual investors, however, are mainly interested in summaries, Pozen said. “The problem has always been how much legal protection the issuer gets if something is omitted from the summary and an investor complains,” he said. “The SEC is finally coming to grips with that. But it’s a tough issue.”
Audit Quality Defined
Panelists also discussed the effects of Sarbanes-Oxley on outside directors and auditors. Pozen said the single most important change spawned by SOX “is the fact that now almost all outside directors need an executive session every quarter” without any management present.
“If the CEO and management are not present, people feel a lot freer to discuss their views,” he said. “I’m almost sure that everything significant that happens at board meetings occurs personally in that executive session, and that turns out to be incredibly important.”
Pozen also credited SOX for underscoring the notion of “critical accounting polices.” Audit committees now rely on their auditors more than ever to tell them what the big accounting judgments are, “because if you’re on an audit committee, it’s very hard to even pinpoint what are the accounting issues.”
Overall, according to a recent survey by the CAQ, audit quality in the United States has improved in the six years since SOX was signed into law. The report found that nearly 80 percent of more than 250 audit committee members who responded consider their current overall audit quality as either “very good” or “excellent.”
Despite the survey’s positive outlook, however, panelists warned against having auditors serve as “a cop on the beat.” While auditors should be involved, “they shouldn’t be making the final decision with respect to management’s problem,” Kroeker said.
Mahoney agreed: “To me, audit quality is much more about creating influence to get the financial statements right.” Companies today focus too much on only examining things that have gone wrong, rather than focusing on right answers, he said.
“I certainly agree that the auditor has to find materialities. There’s no question about that,” Mahoney said. “But if that’s all that they do, I think that’s an issue of the profession that will result in poor financial reporting over the long term.”
The CAQ will present more of its findings on June 4 at Compliance Week’s annual conference held in Washington, D.C. (For details on attending the conference, please see the box at right.) It will then hold a final panel of its Public Dialogue Tour in Washington on July 22, and the findings will be incorporated into a report the CAQ will issue later this year.