American and British regulators agreed recently to an information-sharing arrangement, which they believe would have helped detect an accounting scheme at Lehman Brothers called Repo 105. Near the end of each quarter, a UK subsidiary of Lehman would swap some of its assets for cash with a third party, which would sell these assets back to the Lehman subsidiary for cash just after the end of the same quarter. To reduce the amount of debt on its balance sheet, Lehman booked these swaps as asset sales rather than borrowings. But regulators alleged that Lehman engaged in a major accounting fraud by deceiving the public about its true financial condition.
Author Robert C. Pozen
To improve board oversight of financial transactions like Repo 105, it is more important to change the approach of corporate audit committees than to enhance the information-sharing among accounting regulators. It appears that members of Lehman’s audit committee were not aware of the many repetitions of the Repo 105 transactions. Their ignorance says a lot about what is wrong with the current approach to the audit process in publicly traded companies.
This commentary originally appeared on the Financial Times website.
In compliance with the Sarbanes-Oxley Act of 2002 and related exchange rules, all members of the Lehman audit committee were independent and the committee’s chair was a financial expert. Following other rules, the audit committee made sure that the company’s auditor (Ernst & Young) was independent of Lehman, and met privately with the engagement partner of the audit firm without Lehman management present.
Under Sarbanes-Oxley and related Securities and Exchange Commission rules, Ernst & Young supplied the audit committee with a list of Lehman’s significant accounting policies. Ernst & Young was also specifically obligated to report to the audit committee any significant disagreement with management on financial reporting. However, Ernst & Young apparently went along with Lehman’s accounting treatment of Repo 105. The audit firm and Lehman relied in part on a letter from UK counsel opining that Repo 105 constitutes a sale under UK law.
In short, to paraphrase Donald Rumsfeld, members of Lehman’s audit committee did not know what they did not know. Unfortunately, audit committees are often in this state of ignorant bliss. The committee members are deluged with massive amounts of complex information, including detailed financial statements and lengthy SEC filings. It is extremely difficult for committee members, no matter how intelligent, to pick out from this mass of data the key judgments made by management and the external auditors in putting together these statements and filings.
To become more effective, audit committees should request four specific pieces of information. First, the auditors should highlight any set of transactions – such as sales or borrowings as well as off balance sheet and tax-motivated deals – which occur repeatedly at the end of quarters or financial years. It is quite reasonable to design one complex transaction in response to a unique set of circumstances; it is more suspicious if similar transactions occur frequently near the end of a reporting period.
Second, the auditors should identify any material item where the accounting literature allows alternative methods of presentation and explain why the company believes its alternative is preferred. For example, the accounting literature allows, but not does not require, companies to use hedge accounting in certain circumstances. Committee members should be fully briefed on whether and why the company decided to use hedge accounting.
Third, and perhaps most importantly, the auditors each year should provide the audit committee with any material differences in significant accounting policies between the company and its four or five main competitors. This comparative analysis should cover policies such as revenue recognition, warranty obligations, retirement plan obligations, tax reserves and valuation of goodwill or other intangibles. Some of the differences in accounting treatment will be due to differences in how the companies run their businesses; others will represent accounting judgments that the committee should fully understand.
Finally, the company’s chief financial officer should provide the audit committee with analyst reports discussing the accounting methods embodied in the company’s financials or criticizing the “quality” of its earnings. Analysts are quick to point out what they perceive as accounting gimmicks used by companies to improve their revenues or net income. They typically try to get to a company’s core earnings by stripping away these gimmicks as well as non- recurring items, changes in tax rates and gains/losses from currency movements.
All these pieces of information should be sent to the audit committee at least one week before the committee meets. During that week, the chairman of the audit committee should informally discuss with the auditor’s engagement partner any specific issues raised by this information and more generally any “close calls” in the financial reports.
If adopted, these measures will help audit committees identify the key judgments made by management and the external auditors in preparing the company’s financial statements. Instead of trying to find a needle in a haystack, committee members will be focusing on the accounting issues most likely to distort the accurate presentation of the company’s financial situation.
Robert C. Pozen is chairman emeritus of MFS Investment Management, a senior lecturer at Harvard Business School and author of Too Big to Save? How to Fix the US Financial System. He will be speaking at the NACD Directorship Forum in May.