Recently, questions about the quality of corporate financial reporting have been coming from every quarter. According to SEC Chair Arthur Levitt, "we are witnessing an erosion in the quality of earnings, and therefore, the quality of financial reporting. Managing may be giv ing way to manipulation; integrity may be losing out to illusion."
To examine these concerns from the front lines, we talked to several knowledgeable individuals to obtain their collective wisdom regarding best practices for quality financial reporting.
Setting the Tone at the Top
Interviewees agreed that quality financial reporting begins with senior management. "Senior management needs the right type of attitude and integrity," SEC Chief Accountant Lynn Turner said. "They must be 100% ethical all of the time. They must constantly convey the message that high-quality financial reporting is a must."
However, if senior management communicates that financial targets must be met at any cost, they create an environment ripe for "cooking the books." "Senior management sets the tone," said Allan Schulman, managing partner of Milbert Weiss, a securities class actions law firm in San Diego. "If management presses to achieve earnings targets by whatever means necessary, you'll get an environment that breeds fraudulent financial reporting. Fraud starts at the top." Art Wyatt, former FASB member and retired partner of Arthur Andersen, added that "if the troops in the field think management wants managed earnings, they'll do it."
To communicate and reinforce the tone from the top, management needs a written company code of ethics that spells out the penalties for manipulating the financial statements. "There should be a written policy about notifying the board of directors with respect to financial misdeeds within the company," said Joe Wells, chair and CEO of the Association of Certified Fraud Examiners, "especially those of senior management."
According to Kurt Moser, senior vice president of investments with State Farm Insurance, if senior management is in for the long haul, they will account for things differently than if they have a short-term perspective: "One way you can tell that senior management has a long-term orientation is to look at their accounting policies. Management is often pushed into the shortterm world by expectations of analysts and investors for short term results."
The decline in quality financial reporting may be related to the internal control environment, a cornerstone of quality financial reporting. Arthur Andersen's U.S. managing partner Steve Samek asserted that internal controls are under pressure. "Through downsizing, we took away middle managers who were a major part of the internal control environment," Samek said. "It is clearly top management's responsibility to prevent cooking the books."
However, if senior management is perpetrating fraud, the external auditors may be hard-pressed to detect it because senior management has the most indepth knowledge of the company as well as resources to override internal controls, and through collusion can cover up their fraud.
Board of Directors
The board of directors should set clear expectations for quality financial reporting and strongly endorse fair, as opposed to acceptable, financial reporting. Each board member must be knowledgeable of the industry, have sufficient knowledge of financial reporting, and be willing to ask tough questions and assess the answers.
"The board must be able to recognize a financial problem," Moser said, "and they should feel a sense of urgency to attack it." Albrecht gave some additional advice: "The board of directors should be sure the company's numbers are realistic given those of other companies in the industry."
All those interviewed strongly believe the majority of the board should be independent, have no significant financial interest in or dealings with the company, and have no significant financial or personal relationships with senior management. …