Over the past twelve months, accounting scandals have tarnished some of the most illustrious corporate names and embarrassed some of the putatively smartest investors on Wall Street.
Executives at Valeant Pharmaceuticals and Philidor RX Services are arrested and charged with fraud and money laundering following revelations that Valeant engaged in “channel-stuffing” with its captive mail-order pharmacy to inflate profits that led to Valeant shedding 90% of its market value. Storied British retailer Tesco pays a fine of $162 million over an accounting fraud that resulted in profits being overstated by $295 million. Venerable heavy equipment manufacturer Caterpillar is accused by a whistleblower in its finance department of using a dubious tax avoidance scheme to shift billions of dollars in profits to Switzerland to avoid U.S. taxation with the assistance of its auditor. The SEC uses satellite imagery to demonstrate that Mexican homebuilder Homex is booking $3.3 billion in revenues for homes that have never been built.
Normally only particularly high profile and egregious accounting scandals capture the attention of the mainstream financial media. But there is a regular drumbeat of allegations of accounting improprieties from stock bloggers, SEC inquiries, and whistleblowers that need to be assessed and responded to by management and boards of all public companies, both big and small. Many of these issues turn on the reasonable exercise of accounting judgment and accounting estimates, and can be remedied through improved disclosure or policy adjustments. Other accounting accusations spiral into wide-ranging inquisitions that shatter corporate reputations, permanently impair shareholder value, and are fatal to executive careers.
So how can management most effectively respond to an accounting crisis? And more importantly, what can be done to avoid a crisis from occurring in the first place?
Defining an Accounting Crisis
An accounting crisis is any event that substantially undermines the confidence of investors and regulators as to the accuracy of a company’s financial statements and the competence and integrity of its management.
Importantly, an accounting crisis is not triggered by changes to reported financials, but rather the impairment of confidence. Companies regularly make adjustments to the value of various assets and earnings based on changes in the economic environment. As long as there are satisfactory business reasons for these changes, investors may be disappointed, but the financial statements remain credible. It is when investors lose faith in the integrity of the process through which financial information is reported and begin to doubt the motives of people producing those statements that an accounting crisis emerges. Like a good crime story, a full blown accounting crisis requires a compelling motive, a villain or cast of villains, and a chain of evidence.
Some of the potential triggers for an accounting crisis can include:
- Repeated late filings that raise doubts about the competence of the accounting staff
- Missed deadlines for filing extensions that result in stock trading being halted or delisting proceedings beginning
- A qualified audit opinion with substantive concerns about accounting and/or internal control issues
- A short seller attack focused on the accuracy of financial statements or accounting policies
- Board investigations into self-dealing or violations of the foreign corrupt practices act (FCPA)
- Material unexpected write offs in asset valuations
Some accounting crises emerge full blown with damaging novella length reports that are backed by reams of credible evidence. Others begin with a steady drip of news reports or investor inquiries that slowly fray at the edges of investor confidence. Sometimes the issues are managed discretely behind the scenes in board rooms and meetings with regulators. Whereas in other cases, activist investors square off taking opposing sides of an issue in television interviews and financial conference presentations.
Whichever way the narrative unfolds, an accounting crisis is likely to be one of the most distressing events that management and board members will ever experience. It has the potential for catastrophic loss in corporate value and access to the capital markets. The consequences can include the end of public company status, shareholder lawsuits, auditor resignations, a damaged reputation with customers, SEC investigations, and even prosecution by the Department of Justice (including possible fines and jail time.) With so much at stake, an accounting crisis provides zero room for error.
Why Are Accounting Crises So Frequent?
Managers of public companies are frequently under intense pressure to meet quarterly earnings targets, which they are told is the key to a levitating share price. Not only is management compensation frequently tied to these metrics, CEOs will often be summarily ejected from the corner office for repeatedly failing to meet the expectations of “the Street.” This can create incentives cross over from gently “managing” earnings to outright “manufacturing” reported profits.
In fact, a recent study authored by professors at Cambridge and USC showed a positive correlation between having a reputation for consistently beating earnings estimates and crossing over into aggressive accounting and then outright earnings manipulation. Not surprisingly, the companies who fit this profile were often rewarded with high market values and “strong buy” analyst ratings up until the point that accounting hijinks were revealed.
While activist investors in theory should have an incentive to monitor the accuracy of financial reporting, these funds have increased the pressure to maximize near term shareholder value. Some of the methods activists often advocate, including leveraged share buybacks, cash distributions, aggressive price increases, and cuts to discretionary R&D, can also undermine business sustainability and lead to more creative profit enhancement techniques.
Fundamentals-based short selling has been a painful occupation during the extended equity rally in recent years, in which the stocks of even mediocre companies have drifted upwards. But short sellers who are able to craft convincing and sensational stories of accounting misdeeds that shake investor confidence can often capture enormous profits in a matter of hours. While some of these short seller reports have unearthed substantial misdeeds and led to the demise of their targets, other "short and distort" reports take poorly understood aspects of a company’s financials or business model and construe them in the most negative light as indicia of fraud.
As long as there are profits to be made with these tactics, company management and the board needs to be prepared to respond effectively to short seller raids.
Risk Factors for an Accounting Crisis
While there are a wide range of factors that can lead to an accounting crisis, there are certain warning signs that should cause an investor or board member to at the very least ask more questions. Potential red flags include:
- Increasingly aggressive accounting treatments in which reported earnings and cash flow begin to diverge significantly
- Insufficiently qualified staff in the finance, accounting, and internal controls functions
- A large percentage of profits coming from affiliates or related parties
- Acquisition binges, particularly when material assets are purchased from related parties or mysterious entities
- Margins that wildly diverge from industry norms when offering comparable products or services
- Lack of senior level attention or industry knowledge by the company’s auditors or outsourcing of field work to a third-party firm
No one of these factors conclusively indicates that the financial statements are inaccurate, but they are causes for additional scrutiny and skepticism. At the heart of most accounting scandals is some sort of financial “black box” that is generating an outsized portion of the company’s profits and which is poorly understood by the market. Short sellers seize on this opacity to claim that the profits are fictional and that management has duped investors. Without owning the confidence of your shareholders and in a vacuum of information, investors may sell immediately rather than wait for clarification. Perhaps the biggest red flag for a potential accounting crisis is when management cannot provide a clear and convincing answer to the question: “How does this company make money?”
What to Do When a Crisis Breaks Out
An accounting crisis can arrive in any number of ways. A whistleblower contacts the Board or regulators. A short seller publishes a report. An auditor decides to withhold an opinion. Or a negative media article appears. Often it occurs at the worst possible time, when senior management is on an airplane or otherwise unreachable.
As with a heart attack or stroke, the response at the very outset of an accounting crisis will often determine the outcome.
This is why it is important that every company has a written Crisis Response Plan that spells out how it will react to a range of crisis level corporate events, including accusations of accounting malfeasance or fraud. This Crisis Response Plan should be stress tested with a crisis fire drill at least once a year to make sure all the crisis team members are comfortable in their designated roles.
Responding rapidly and decisively enables a company to assume control of the narrative, rather than always being one step behind the parties who are alleging improprieties. Sophisticated short sellers will often stage a raid with multiple revelations in reserve and will orchestrate media coverage so as to amplify the attention that their allegations receive.
Every minute counts when an accounting crisis strikes and the company must move quickly to stanch hemorrhaging market value by:
- Reaching out immediately to its stock market and regulators to let them know that there is a process in place, that disclosure will be forthcoming, and to determine if a trading halt is appropriate
- Presenting the audit committee with a credible assessment of the accuracy of the relevant accusations and/or auditor concerns
- Freeze all stock trading by management and the board
- Determine if specific devices or data needs to be secured
- Summarize data that refutes allegations and package the information in an investor-friendly format
- Hold a public investor conference call the next day if possible
- Schedule one-on-one calls with top holders following the public call
- Follow up with supplementary, factual, non-argumentative investor materials as appropriate
One of the most consequential decisions at the onset of any accounting crisis is whether the response will be overseen by management or whether it requires an independent investigation under the direction of the Audit Committee or a Special Committee of the board. Generally, if the board has a deep understanding of the business and accounting issues involved and has been kept apprised of ongoing investor concerns, it is more likely to delegate the response to management. Whereas, if board members read news reports and are learning about issues they were never aware of in the past, they are likely to hit the panic button and place management on the sidelines.
While an independent investigation may in some cases be the appropriate solution, it is certain to be a very expensive process that substantially prolongs the timeframe during which the target company is going to be operating under a cloud of suspicion. Having legal investigators and forensic accountants descend on a company can be extremely disruptive to normal operations and causes tremendous strains between management and the board.
Management and boards who successfully manage an accounting crisis will be able to preserve long-term business value and maintain a full range of corporate options. A short-term decline in the share price actually presents an opportunity for well-informed investors to add to their positions at discounted prices.
In the weeks and months following an accounting crisis management should revisit top holders in person and assess gaps in the market’s understanding of their business model or important accounting policies. The company should take a hard look at its existing disclosure practices and see if there are ways to make critical business decisions more transparent. Working with the Audit Committee, management should scrutinize the bench strength of its accounting and internal controls staff. While an accounting crisis does not always indicate that nefarious behavior is afoot, it certainly suggests that the Board should take a hard look at how it has been disclosing its business operations and financial performance and seek every opportunity for improvement.
The single biggest mistake management can make in response to an accounting crisis is to develop an unhealthy obsession with short term fluctuations in the stock price or the tactics employed by short sellers. In the end, the fundamentals of the business will determine shareholder value, and the rotation of uninformed investors out of the stock will set the basis for a sustained rally once short sellers have to close out their positions. After the most substantial allegations of short sellers have been responded to, it is time to get back to business and prove naysayers wrong with documented performance.
How Can You Avoid an Accounting Crisis?
Far preferable to capably managing through an accounting crisis is to avoid one altogether.
Just as there are specific risk factors for an accounting scandal breaking out, there are a number of best practices that can make it far less probable that a company will ever be plagued with allegations of improprieties. Board members who wish to avoid the harrowing experience of being accused of financial misdeeds in print and having their lives consumed by meetings with lawyers and forensic accountants should insist on these steps as a preventative measure. After all, do you really need to wait for a heart attack before you set aside the cigarettes and cartons of ice cream?
- Provide realistic guidance that is consistent with the level of actual volatility in the business. To determine what range of guidance is appropriate to provide investors, management should take a hard look at how results have varied against internal forecasts or performance targets in the past across the business cycle. This dispersion can help guide a discussion as to the amount of detail it is appropriate to provide in guidance, or if guidance should be provided at all. Opting out of the earnings management game reduces the incentives for management to cross over the line and can help build a reputation for integrity in your sector.
- Have an engaged Audit Committee that actively discusses accounting policies with management and the auditors and has a deep knowledge of the business model. Regularly brief the Audit Committee on the “tough questions” that come up in investor meetings so that they are aware of where shareholders are confused or concerned. An Audit Committee that has thoroughly debated critical accounting policies is unlikely to be spooked when an outsider calls those decisions into question.
- Perform a stress test of your ability to effectively respond to an accounting crisis with a hypothetical media report or whistleblower to see how effectively your team can mobilize and respond. Use a “devil’s advocate” to articulate the short case against your stock and see where your disclosure practices may need shoring up.
- Carefully scrutinize acquisitions and distribution channel relationships to identify any actual or perceived conflicts. If a transaction cannot be accurately and fully disclosed in a way that would make economic sense to an outside investor, then it should be a pass.
- Make risk management a core discipline in corporate decisions. Effective risk management requires investing in qualified accounting and internal controls staff who have the autonomy to do their work professionally. But it also means aligning compensation with business sustainability and value creation over a period of multiple years. Most of the techniques employed by the perpetrators of accounting misdeeds have relatively short half lives. Take away the profit incentive and they become less attractive.
- Disclose, disclose, disclose. Absent actual fraud, the most common cause for accounting scandals is poor disclosure practices. Management either failed to disclose some aspect of their business or a material transaction completely, or they puffed something up to appear more significant than it is. Rather than approaching corporate filings with a compliance eye to the minimum that must be disclosed, companies should ask what information would be most useful to an investor to understand their business.
Over my many decades in the audit business, I have experienced accounting crises from multiple perspectives — as an Audit Committee member, as an auditor following the resignation of the original public company accountant, and as an independent forensic accountant helping investors or board committees get to the bottom of a company’s financial condition. I vividly recall one instance of being locked in a hotel suite for 48 hours with the financial press camped outside as grown men screamed and wept while debating the best approach to an escalating accounting scandal.
Each of these experiences was a time of tremendous learning and professional growth for me. But for management and the board going through it, dealing with a major accounting crisis can be excruciating and in some cases career ending. I hope that the lessons from those episodes may be of some benefit. As the Irish say, “May you always walk in the sunshine.” But in case it rains, you are free to borrow my umbrella.