An informal survey by Financial Executives International Research Foundation indicates chief financial officers (CFOs) expect tough boardroom sessions this year. Senior audit partners for Deloitte & Touche (D&T) offered practical advice during a teleconference co-sponsored by the Foundation on January 17, 2002. The best boardroom strategy: Formulate your responses in advance to the two key questions likely to be uppermost in the minds of board members: “What happened at Enron?” and “How can we prevent it from happening here?” A systematic approach to answering these questions provides the foundation for a three-step process suggested by D&T.
(1) Start with the practices that hurt Enron. “Incomplete and conflicting news stories have created a great deal of confusion,” explained Greg Weaver, D&T’s national managing partner of assurance. “Given the volume of information – and probably misinformation – it’s difficult for anyone to fully understand these events.” To cut through the confusion, D&T prepared a tentative list of the primary factors contributing to Enron’s financial restatement (and perhaps its business failure as well). The factors include:
- Use of unconsolidated special purpose entities (SPEs) structured to keep financing and risk mitigation transactions off the financial statements.
- Use of fair value accounting together with the questionable validity of complex models used to value derivatives in energy contracts with 20-30 year lives.
- Use of debt liquidity accelerators with triggers based on the company’s credit rating and/or stock price. The triggering of these accelerators created a liquidity crisis for Enron.
- Acceptance of benefit plan practices that allowed concentration of company stock in employee 401(k) plans.
- Lack of transparency in disclosures, especially about the purpose of the SPEs and the roles of related parties and former management in the activities of the SPEs.
- Adjustments to equity for stock sold for notes receivables.
- Adjustments to earnings for prior passed adjustments by the company’s auditors.
D&T advises CFOs to take the initiative in determining whether their companies have controls or safeguards in place that would prevent the use of similar practices and need for similar adjustments. But keep in mind, cautions Mr. Weaver, “Enron’s issues may not be your issues, and no one knows where the next failure will come from.”
(2) Identify other critical risks and controls. To address the broader concerns about disaster prevention, companies need effective controls and adequate risk management systems. Jonathan Korol, a D&T partner specializing in enterprise risk services, advised CFOs the long-term goals of corporate risk management should include early warning and rapid response systems tailored to each company’s critical risks. Unfortunately, such systems cannot be put in place overnight. In response to today’s top boardroom concerns, Mr. Korol suggested the most immediate priorities for most companies are likely to include reviews of the following:
- The tone from the top, including the use of confidential surveys to assess the perceived importance of corporate ethics and integrity, as well as assessments of the quality of communications with audit committees and evaluations of the seriousness that managers attach to control weaknesses cited by auditors and passed auditor adjustments.
- The nature of existing corporate compliance programs, including a systematic review of the scope of services provided by internal and external auditors to identify critical areas that may not be covered by either.
- The extended enterprise, including an analysis of the risks associated with the company’s network of relationships with entities not 100% owned or controlled by the company, such as joint ventures, licensing arrangements, marketing alliances, outsourcing relationships, and partnerships. One reason why these types of relationships can pose control weaknesses is because they typically involve minimal upfront cash investments so they may circumvent expenditure authorizations or other traditional controls.
Mr. Korol said the concept of the extended enterprise is important today, not just because of Enron, but also because it, “adds another dimension to the control environment.” He cautioned CFOs, “You may be surprised to find how many such relationships exist within your company.”
(3) Anticipate changes from regulators. Robert Keuppers, senior technical partner and national managing partner of professional practice at D&T, added a third step in the process of answering “How can we prevent it from happening here?” He urged CFOs to seize the opportunities (and, in some cases, obligations) to take a “fresh look” at their financial reporting as a result of documents that were released by (or came to the attention of) regulators within the past few weeks or days. Reasons for a “fresh look” include:
- Cautionary advice and a recent SEC enforcement action regarding pro forma information. Mr. Kueppers indicated he has reason to believe there are at least “a half dozen” cases now in process in addition to the first case reported by AccountingWEB last week.
- Disclosures about critical accounting policies. SEC’s chief accountant has urged companies to identify their most critical accounting policies and provide more “plain English” explanations about these policies, along with related estimates, judgments and sensitivities, in the MD&A (Management’s Discussion and Analysis) portions of reports.
- SEC’s new Fortune 500 review program. Starting this year, the SEC’s Division of Corporation Finance will be monitoring the 10-Ks of all Fortune 500 companies. If issues are identified, the companies will receive comment letters and their filings will be subject to full review. Mr. Keuppers said the SEC is specifically looking for examples of disclosures that are deemed deficient in explanation and quality.
- Suggestions in the Big Five petition. The Big Five accounting firms petitioned SEC to issue an interpretive release that would help improve annual reporting for 2001, and SEC’s chief accountant has urged companies to consider the guidance in the petition.
- An impact statement recently issued by the AICPA and the Big Five firms. Described by Mr. Keuppers as a “must read,” this document pulls together many of the environmental factors and risks affecting financial reporting. It includes a call to action by management, audit committees and outside auditors, and it can serve as a checklist for many of the questions management may be receiving at this year’s board meetings.
During the course of the hour-long “virtual forum,” D&T partners answered questions from participants and interpreted results of on-line polls conducted simultaneously with the presentation. A full audio file will be available in the near future. Cutting across the many subjects covered in the teleconference, Greg Weaver summed up, “It’s not business as usual. When all is said and done about Enron, there will plenty of blame to go around.” His advice in a nutshell: “Keep things in perspective and remain vigilant for warning signs.”
Highlights of the conference were summarized by Rosemary Schlank for AccountingWEB. Marla Bace, chief operating officer of the Financial Executives International Research Foundation and co-host of the teleconference, invites readers to download Deloitte & Touche’s powerpoint presentation and view a list of upcoming teleconferences and webcasts. The Foundation hopes to publish the results of the virtual forum, including on-line polls conducted during the teleconference, in an upcoming Executive Report. The Foundation is an independent body supported by independent grants for research by companies and individuals. Its mission is to provide financial education to the executive level financial manager.