Finance GRC: Putting the Spotlight on Financial Statement Quality

In his remarks prior to signing the Sarbanes-Oxley Act (SOX) of 2002 into law, President George W. Bush said:

This law says to honest corporate leaders: Your integrity will be recognized and rewarded because the shadow of suspicion will be lifted from good companies that respect the rules.

This law says to corporate accountants: The high standards of your profession will be enforced without exception; the auditors will be audited; and the accountants will be held to account.

The law says to shareholders: The financial information you receive from a company will be true and reliable; those who deliberately sign their names to deception will be punished.

The law says to workers: We will not tolerate reckless practices that artificially drive up stock prices and eventually destroy the companies, the pensions and your jobs.

More than 5 years after SOX was enacted, most business people affected by the Act would agree with President Bush's claim that it represents “the most far-reaching reforms of American business practices since the time of Franklin Delano Roosevelt.”

I. IMPROVING THE QUALITY OF FINANCIAL DISCLOSURES: A NEW MANAGEMENT ACCOUNTANT CORE COMPETENCY AND CALL TO ACTION
In addition to being the most drastic set of changes ever involving the regulation of securities. SOX has also sown the seeds of a new and critical core competency for management accountants – helping their organizations produce materially fault-free financial statements. Under the new SOX-related rules from both the Securities & Exchange Commission (SEC) and the Public Company Accounting Oversight Board (PCAOB), the discovery by a company’s external auditor of, even one material error in the draft financial statements, may result in the company being forced to publicly report that it has “ineffective” controls over financial reporting. The key question is:

Is the management accounting profession up to the challenge?
IMA is doing its part to enable management accountants (MAs) to play a more influential role in this area in this area by creating the IMA Finance GRC Research Practice. GRC stands for Governance, Risk Management, and Compliance, an expanding body of knowledge that calls for integration and improvement of current methods and tools used to help ensure corporate objectives are achieved. Finance GRC, a subset of the much broader GRC, focuses on the quality of the financial disclosures being produced by an organization. High quality external financial disclosures are right, relevant and reliable. In today’s world, the overarching goal must be zero material defects in financial statement disclosures. This is a tough standard to meet, but it is one that has a very tangible and significant return on investment, stakeholder trust. Stakeholder trust translates to higher long-term share prices, lower cost of capital, better credit ratings, less regulatory intervention, and reduction of the significant costs that accompany the restatement of financial statements. The current rate of U.S. public company restatements is approximately one in 10. The costs to rectify material errors, discovered in subsequent periods are enormous. Improving the unacceptably high rate of financial statement “defects” must be the new mantra of management accountants.

Through the Finance GRC Research Practice, IMA is

• building management accountants’ awareness and knowledge of Finance GRC by pulling together key resources on our website;
• conducting new research studies (with research partners and corporate sponsors) to better understand the root causes of financial defects and the correlation between major financial statement errors and restatements and the determinations on controls effectiveness made by management and external auditors; and
• developing educational programs with modules focused on FGRC.

II. THE BUSINESS CONTEXT AND CALL TO ACTION

At the turn of the 21st century, an alarming number of high profile, seriously flawed financial statements emerged – even though these financial statements were produced and certified as correct by senior management, reviewed and approved by the audit committees of the boards of directors, and certified as “fairly presented” by external auditors.

In response to the steady decline in the quality of financial statements, the Sarbanes-Oxley Act of 2002 (SOX) was passed with the stated goal:

To protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to securities laws, and for other purposes

III. FINANCIAL STATEMENT DEFECT RATE STILL HIGH DESPITE BILLIONS SPENT
The implementation of SOX has highlighted the glaring deficiencies in the existing risk and control assessment methods and tools. In a large number of the companies forced to issue restatements, both management and external auditors had publicly certified--often in good faith--that the original financial statements were materially correct and that the internal control over financial reporting (ICFR) systems that supported the statements were “effective.” Research conducted by Glass, Lewis & Company and Audit Analytics shows that a large percentage of the material control weaknesses reported to the SEC each year by U.S. public companies are not proactively identified by management or auditors. Instead these weaknesses are reported because auditor testing of the account balances reveals material errors in the accounts, prima fascia evidence that the accounting control systems that both management and auditors had previously believed to be “effective” were, in fact, ineffective at preventing material errors prior to external audit review

If the goal is to reduce the high incidence of materially wrong financial statements, the current frequency of restatements and accounting corrections graphically demonstrates that more needs to be done. This is a critical responsibility that must be shouldered by four key groups:

1. management accountants that design and maintain ICFR control systems and prepare the financial statements,
2. external auditors that opine on a company’s ICFR system and financial statements,
3. regulators that develop and maintain accounting and auditing standards, and
4. educators who provide both primary and ongoing professional development for internal and external accountants and auditors.

The issue of materially wrong management- and auditor- certified financial statements isn't unique to the United States. Management in public and private organizations around the world continue to provide auditors with draft financial statements that are later determined to contain a significant number of material errors that must be corrected or, stated in quality vernacular, reworked. In some cases these errors in management’s draft statements are found by the external auditor and corrected prior to being released to the public. Unfortunately, this isn't true in every case. The public release of materially unreliable publicly released financial statements continues to be a serious and growing global problem.

Better and more cost-effective risk and control assessment methods and tools are required. The causes of unreliable management- and auditor-certified financial statements need to be systematically studied, common root causes identified, and practical solutions developed to provide greater assurance to stakeholders that they can rely on the attestations by management and auditors that the audited financial statements are correct. Costly and ill-conceived solutions, crafted without a clear understanding of the real root causes of material errors,  or solutions that apply shotgun-style approaches that don’t focus adequate resources on the statistically probable causes will not solve the problem.

More needs to be done to ensure that the accounting disclosures relied on by a wide range of stakeholders, owned are right and reliable – and it must be accomplished at a cost that is palatable to management and investors. What is needed is a relentless focus on the consistent production materially fault-free financial disclosures at the lowest possible cost. It's time to focus on the both the macro- and micro- level systems that produce public financial disclosures and reduce the current shockingly high rate of defects. The collective wisdom and body of knowledge of the quality, risk management, control, organizational and human behavior, and internal and external audit disciplines must be integrated to succeed. It's time to stop treating each of these disciplines as silos and focus on improving the performance of enterprise-wide governance risk and compliance processes.

A logical starting point for research is the large population of public companies that have issued management- and auditor-certified financial statements that have been proven to be materially wrong. According to a recent study by Audit Analytics, the number of large companies that filed certified financial statements with the SEC subsequently proved to be materially wrong in 2005 was a whopping 620. This number dropped to 512 in 2006, but that still means that 13.3% of large, sophisticated companies with large accounting staffs issued materially wrong financial statements. Simply stated, this means more than 1 in 8 management- and auditor-certified financial statements issued with unqualified auditor opinions had to be restated to adjust for major errors discovered in subsequent periods. Smaller U.S. public companies, who don’t yet have to comply with the onerous SOX Section 404, fared only slightly better, with restatements being issued by 778 companies in 2005 and 1,108 companies in 2006.

Primary responsibility to correct this situation rests with the internal and external accounting and auditing professions. It is time to set aside territorial claims and boundaries and work together to improve the frequency of reliable financial disclosures and reduce the number of accounting restatements. The SEC and PCAOB, regulators, the American Institute of Certified Public Accountants (AICPA), IMA, and the internal and external audit communities must work together to identify and treat the root causes of these problems and improve the performance of Finance GRC processes.

IMA has laid the foundation for this effort by creating the Finance GRC Research Practice. If there is to be any rapid progess, more money is needed to fund root cause identification and analysis research and to hold forums to explore and develop practical cost-effective solutions that really work.

The frequency and magnitude of “material defects” in financial statements has many parallels to the reliability of cars produced by the automotive and manufacturing sectors in North America in the 1970s.Just as car the manufacturers in the U.S. learned over time to make fewer mistakes when designing and building their cars the accounting profession – which includes internal and external accountants as well as auditors can, and must, do better. High stakeholder trust is inextricably linked to economic success, a lower cost of capital and higher share prices. Fundamentally, winning the game of reliable external disclosures isn’t about sparing corrupt CEOs, CFOs and Controllers from going to jail. It isn’t about reducing the large fines and humiliation that can arise from the publication of misleading data. It isn’t about reducing the cost of capital to drive business growth and keep share prices up. At the core of the problem it is about protecting the economic well being of whole national economies. Without stakeholder trust, the willingness of individuals and companies to invest and lend is reduced. Without the necessary capital, growth is stifled and quality of life deteriorates.

The stakes are high. The time to get serious about tackling materially unreliable financial statements is now. As expensive and onerous as SOX was in the first five years of its young life, it has only made a small dent in solving the bigger problem. Better researched, more creative solutions are required. Will you help us with this effort?