Directors need to understand the underlying economic issues when presented with a company’s financial statements. Among other things, Enron and WorldCom revealed that directors were not aware of those issues. Which is why, as these Ivey professors suggest, two important questions must be resolved: What is a board’s responsibility for a company’s financial statement, and how might a board best fulfill that responsibility?
Recent high-profile financial reporting scandals such as Enron and WorldCom have raised questions about the role of the boards of these companies and others in ensuring that financial reporting is complete and transparent. Two questions might be asked: What is the responsibility of the board of directors for its company’s financial statements, and how might the board best fulfill this role? In the end, from our perspective, the silver lining to these and other financial disasters in 2001 and 2002 is expected to be heightened interest in corporate governance and the critical role financial reporting plays in this process.
It is important to keep in mind that the Enron and WorldCom situations are not representative of the issues facing boards of directors. In both these cases, it is alleged that senior executives committed wrongdoing, if not fraud. It was the magnitude of the collapse, and also the speed, that brought issues of corporate governance and the roles of the important players under scrutiny. In our view, these cases demonstrate two different problems facing directors who are trying to do their jobs properly.
In the Enron situation, the first problem facing a member of the board would be his or her ability to understand complex financial planning structures, “special purpose entities” (SPEs) and their uses. These complex corporate structures have many legitimate purposes such as asset securitization and risk management, and have been and continue to be widely used. What was their main purpose in Enron’s case? Were they effective? Was this a legitimate use of SPEs. Since board members typically have limited time to devote to any one company, they would need considerable financial skills to understand and evaluate the particular use of the SPEs. Further, the complexity of SPEs is mirrored by the accounting rules used to measure and disclose their economic impact. In this situation, it is alleged that senior management in the company attempted to get around the accounting rules in order to increase reported revenue and decrease reported debt. Rather than being used to actually manage risk, it appears that the SPEs might have been used to manage how outsiders viewed the riskiness of Enron itself. The main issue, from an accounting viewpoint, is whether the accounting rules required that certain SPEs should have been consolidated when the financial statements were prepared. Based on published reports, the complex financial structures and their reporting confused even sophisticated users of financial statements.
Most individuals would not want to be appointed to the board of a company with such complex transactions unless they fully understood them. The nature of a company, however, can change significantly after a board member assumes his role. Consider the dramatic change in Enron’s revenues over its last six years of existence (Exhibit 1). A tenfold increase in revenues, especially in the very complex area of buying and selling energy and other esoteric products like broadband capacity, must have strained even the most sophisticated directors’ ability to understand the company and the activities of its management.
The WorldCom situation appears to highlight a less complex financial accounting issue than accounting for SPEs, but no less troubling. In this case, it has been reported that the company accounted for certain transactions, in excess of US$3 billion, as capital assets rather than operating expenses. This had the impact of increasing both the reported income and the assets on the company’s financial statements. This was not a very sophisticated accounting issue or very difficult to understand. Like many accounting measures, some level of judgment might have been required. However, if these decisions to capitalize certain expenditures rather than expense them were made without the board members’ knowledge, how could the board question management’s decisions or judgment? This lack of awareness, at least in the short run, might have been in spite of the existence of normal internal control systems.
Do, or perhaps should, the boards of these companies have the responsibility to prevent these types of events? Or more realistically, assuming that Enron and WorldCom are anomalies, what are realistic expectations concerning a board of directors’ role and responsibilities for complete and transparent financial disclosure? What kind of background and skills might a board need to be able to fulfill this responsibility? How might changes in board members’ behaviour help avoid similar occurrences?
Legal Role of Board of Directors: Financial Reporting
Legally, the board must approve a corporation’s financial statements, and generally two members of the board sign them. Securities commissions in the U.S. have recently expanded this requirement, so that the board or its audit committee must also now approve interim financial statements. At the moment, TSX-listed companies are not required to have an auditor review their quarterly statements, but many experts expect this will change soon.
In addition, beginning this summer all audit committee members of TSX-listed companies are required to be financially literate, and at least one of them must have accounting or related financial expertise. One might question what is meant by financially literate; however, we believe that this is a positive move forward. Like most changes designed to correct perceived problems, it deals with structural changes.
We strongly support the proposals advocating audit partner rotation. The audit committee was created in response to concerns that the auditor is not completely independent of management, because, for practical purposes, management selects the auditor. Another very real concern is that the relationship between the auditor and management can become too personal, and the players can become complacent. The rotation of the head audit partner every five years should significantly reduce this risk.
A strong willingness to both question issues and to speak out in meetings is a necessary first attribute. It is far from easy for one individual to question an idea presented by management. We believe that the board chair should encourage everyone to ask questions. If all board members are chosen for their competence and perceived contributions, then their questions and concerns should be supported and examined. If this is not the case, one is left wondering why they were chosen to be on the board.
We also believe that in the area of financial reporting, there may be an unwillingness to admit to a lack of understanding. We believe that boards should help all of their members to develop financial literacy, not just those who sit on the audit committee. We are not suggesting that every board member should know every accounting rule. However, board members do need to understand the business of the company and the risks involved. In contrast to the simple withholding of information by some level of management in the WorldCom situation, the Enron directors were faced with complex transactions using complex business structures. We think the Enron board may well have reduced the disaster if they had asked some penetrating business questions years earlier.
It is our contention that the first step in financial reporting literacy is to understand the underlying economics of the business. A discussion of whether an expenditure has future benefit, and therefore can be legitimately capitalized rather than expensed, is different from trying to cope with and understand Enron’s complex activities and organizational structure. If board members do not understand SPEs, or have only a vague understanding of their uses, it is difficult for them to even begin to assess whether they have been adequately measured and communicated for financial reporting purposes. Even the most expert accountant struggles with the measurement of these complex financial instruments.
Clearly, directors require a better understanding of financial reporting. The various regulators, OSC, SEC and others, are responsible for mandating the corporate governance rules and skill requirements of board members. However, in order to apply these skills, board members need to ensure they are knowledgeable about the economics of the company and its business model. We believe that Enron’s financial reporting might have been different if the board, alerted by Enron’s growth in revenues and their complex sources, had begun to ask the types of questions necessary to understand the company’s business model. A reliance on the systems and its data may not be enough. The board needs to understand the financial accounting data, which in turn requires an understanding of the business. The board can then better assess whether the company’s financial disclosures are appropriate, namely transparent and complete, and thereby fulfill its governance responsibilities for corporate financial disclosure.
If Canadian companies want to have access to external capital, they will need to actively encourage reform of the corporate governance system. Changes and enhancement of rules are currently being put into place by the various regulatory institutions. Moreover, we believe that directors need to understand their company’s business in order to assess its financial statements. They will then be more able to assess the inherent accounting risks and fulfill this aspect of their corporate governance responsibilities.
1 Source: Enron Corp. annual reports, 1995-2000.
2 Note: Intersegment eliminations account for the differences between total revenue and the sum of business segment revenue.