Sarbarnes-Oxley was supposed to stamp out the accounting tricks of a decade and a half ago. Here are the ways regulators blew it.
Imagine you’re a portfolio manager in 2002. You bump your head on a doorway in a leap for joy upon the signing of the Sarbanes-Oxley Act, the law that was a response to Enron and other accounting scandals, and sink into a 13-year coma.
That act should have ushered in a new era of corporate honesty and accountability to shareholders in terms of corporate accounting and the auditing profession. It created the Public Company Accounting Oversight Board (PCAOB) to oversee auditors and their work. It provided stable, independent funding for the Financial Accounting Standards Board (FASB) under the auspices of the Securities & Exchange Commission (SEC). It called for the SEC to issue rules reining in hokey earnings release reporting. In short, it should have been a boon for investors, whether institutional or individual.
Now imagine you awaken from the coma and return to your old position (after rehabilitation, of course). Valeant Pharmaceuticals is under fire from a short-seller, in part for not making proper disclosures and for having a shadowy variable interest entity (VIE), giving you Enron déjà vu. International Business Machines’ revenue reporting is under SEC scrutiny. Your head spins from the dizzying array of “non-GAAP earnings” presented in earnings releases; you feel old-fashioned but it’s hard to accept that so many things are excluded from earnings by companies – and the analysts seem to just lap it up. You wonder where the auditors are, or what the SEC is doing. If the FASB was supposed to be strengthened by Sarbanes-Oxley, you wonder why earnings prepared under their prescribed standards are now simply figures perfunctorily filed with the SEC, serving as a platform from which juicier-looking earnings figures are prepared. How could earnings have become so meaningless?
What happened in thirteen years? Why didn’t things change more for the better? A few things might help inform your Rip Van Winkl-esque mind:
- Auditors examine annual financial statements but little else is swept into the scope of their responsibility. The PCAOB has tried on several occasions to force auditors and companies to disclose more information to shareholders about how much was examined and what questions arose during an audit, but has yet to succeed. Regardless, earnings releases aren’t in their purview and never have been.
- The SEC issued rules on reporting non-GAAP earnings, but has done little to enforce them. Maybe auditors don’t have the authority to challenge non-GAAP earnings releases, but the SEC issued Regulation G in 2002. That rule essentially gave companies the scaffolding to build an accounting Tower of Babel, okaying non-GAAP earnings presentations as long as they were clearly reconciled to GAAP earnings. Since then, there has been only one completed enforcement action of the Regulation – in 2009, against now-sold SafeNet Inc. Maybe they don’t find non-GAAP earnings presentations as egregious as others do.
- The FASB shifted its focus on improving financial reporting for investors to the wrong projects. Ironically, Sarbanes-Oxley is partly to blame: it set the SEC off on a nearly decade-long path to converge United States accounting standards with the international accounting standards used in much of the rest of the world, commissioning the FASB to undertake numerous projects that either have not been finished or provided limited benefit to investors.
- Worse, the FASB has devoted much of its energy in recent years to “simplification” projects. These projects, mainly for non-public companies, have not improved public company reporting, and drawn FASB’s attention away from the needs of public company investors. Maybe the most alarming one is a current consideration to give all companies – public and non-public – more latitude in determining materiality for deciding which footnote disclosures to present. Valeant Pharmaceuticals is under fire for not disclosing its relationship with specialty pharmacy Philidor, on the grounds that the relationship was immaterial to the financial statements as a whole. Does more latitude in deciding what disclosures to eliminate seem like the best idea right now? If anything, more prescriptive disclosures seem to make more sense.
- The JOBS (Jumpstart Our Business Startups) Act of 2012 chipped away at disclosure requirements. The weirdly-named act granted confidential SEC reviews of pre-IPO financial statements, reduced disclosure about executive compensation, and limited the number of years for which financial statements are presented, all in the name of reducing the costs of going public – for companies that may well be able to afford the costs of going public, and maybe lowering the bar for companies that shouldn’t even dream of going public. In any case, it helped create a regulatory mindset that focuses not on improving information to investors, but on reducing reporting costs of the preparer and auditor.
Oh yes, and while you were out – interest rates have been near zero for much of the time, leverage has been ratcheting upward, companies have been buying back shares by the ton, and managers have been receiving more and more pay in the form of stock compensation. All of which helps create a virtuous circle, until it becomes a vicious circle. It’s still unsettled as to who’s right: the shorts on Valeant VRX or Valeant itself, and IBM’s IBM investigation might have repercussions for other members of the tech sector. Signs are emerging, though, that the SEC might be waking up from its lengthy torpor. In addition to opening the investigation of IBM’s revenue yesterday, it also announced the closure of its case against five officers of the St. Joe Company for their part in issuing flawed financials having overstated assets and earnings in 2009 and 2010. Earlier this month, it took Grant Thornton to task for auditor independence issues, and last month it finished a case against Stein Mart for presenting financial statements with overstated inventory values over multiple years.
Maybe everything old is new again, Rip. History doesn’t repeat, but it sounds like it’s trying to rhyme.
Jack T. Ciesielski is president of R.G. Associates, Inc., an asset management and research firm in Baltimore that publishes The Analyst’s Accounting Observer, a research service for institutional investors.