Ethics not Compliance Motivates Accurate and Reliable Financial Reporting
One goal of the Sarbanes-Oxley Act is to reduce the number of restatements of corporate financial reports, especially those that result from materially misleading financial statements. The question is, some five years later, whether the Act has accomplished its goals. Recent research released from Audit Analytics seems to indicate it has.
The proportion of corporate financial restatements that had no impact on the bottom line was 59% in 2014. That brought the increase over the past four years to 22 percentage points, which suggests that the Sarbanes-Oxley corporate-governance law has succeeded in bolstering companies’ internal controls over financial reporting.
Among companies listed on major stock exchanges, there were 460 restatements last year that had no effect on income statements, up slightly from a year earlier, according to data and research from Audit Analytics.
“What you’re seeing here is the benefits” of section 404 of the Sarbanes-Oxley Act of 2002, said Don Whalen, director of research for Audit Analytics. “Everything gets better after [section] 404,” Mr. Whalen said.
Effective internal controls help companies detect accounting errors and fraud before they report results to investors and the Securities and Exchange Commission, and allow them to more quickly identify and fix any problems that slip through.
The Sarbanes-Oxley rules, which were hotly debated, required larger companies and their accountants to attest to adequate internal controls, beginning with fiscal years ended after mid-November 2004. Their smaller and foreign counterparts adopted the measures over the next three years.
KBR Inc. made last year’s largest downward earnings restatement, with the engineering and construction company reducing its 2013 net income by $156 million. That was the smallest high for a downward adjustment since 2002; the largest during the period came in 2004, when Fannie Mae wiped $6.3 billion off its prior profits, according to Audit Analytics. Last year’s average downward net-income restatement was about $4.4 million, down from $6.6 million a year earlier.
These results are encouraging although I’m not convinced they will be sustained long-term. The reason is regardless of regulatory requirements – i.e., Sarbanes-Oxley and section 404 – the underlying consideration is good old fashioned ethical behavior. Will egoistic CEOs and CFOs revert to self-interest-driven behavior, as occurred in the scandals of the early 2000s, or have they “seen the light?” If past history is used as a guide, we’re about due for another round of corporate financial wrongdoing.
Enron and WorldCom came on the heels of a financial mess in the savings and loan industry that wiped out billions in shareholder value and led to the closure of thousands of S&Ls in the 1990s. In the 1980s, widespread fraud existed in companies such as ZZZZ Best, ESM Government Securities, and dozens of other companies. I could go back further and point to other scandals but you get the point.
Our economic system is based on the notion of Agency Theory. Corporate managers are supposed to act as the agents of the Principal shareholders and best serve their interests, not those of the managers. However, since these interests may not be exactly aligned because managers seek higher earnings, increases in share price, and somewhat excessive executive compensation, the temptation is there to act in an egoistic manner and not in the best interests of the shareholders. Sure, higher share prices are good for stockholders but not at the cost of false financial reports.
The takeaway from the results reported by Audit Analytics is it appears Sarbanes-Oxley is encouraging more ethical behavior on the part of top corporate executives but the jury is still out whether it will have a long-lasting effect. I’m also concerned about the results because, in accounting, it’s only material restatements that are considered and the results of the study point to 59% have “no impact” on the bottom line. What does that mean with respect to the size of the restatements and how was the materiality determined?
In accounting, as elsewhere in business, the devil is in the details. The Audit Analytics results need further scrutiny. I’m not convinced everything is as rosy as the results seem to indicate. We can’t legislate ethical behavior. It requires a long-term commitment to do the right thing regardless of the costs. Time will tell but my “gut” tells me this will be a short-lived trend. Let’s enjoy it while we can.
Blog posted by Dr. Steven Mintz, aka Ethics Sage, on May 12 2015. Professor Mintz is on the faculty of the Orfalea College of Business at Cal Poly San Luis Obispo. He also blogs at: www.workplaceethicesadvice.com.