I recently had lunch with a senior executive from a big accounting firm who complained about the criticism his firm was facing over audits it conducted at big companies that later were found to have big problems.
In all these cases, the executive said, there was a “well established body of accounting practice” that permitted the company to forestall disclosure or keep certain items off the balance sheet or bury an important fact in a fine-print footnote.
As it turned out, the things these companies obscured were pretty important to investors. Once the off-balance-sheet liabilities were known, the company’s valuation tumbled, executives were fired and lawsuits and recriminations ensued – for the board and its auditor.
The accountants’ defense that “we were just following the rules” just doesn’t fly. For one thing, the so-called “rules” on disclosure don’t exist. The SEC does not provide a strict threshold for disclosure, choosing instead to let companies determine what should be released. The burden is, appropriately, on the company’s board to make the right judgment, consistent with its fiduciary obligation to shareholders.
More than that, auditors ought to stand up as professionals and insist on disclosure when important issues are involved. Sadly, there are few examples when they’ve done so.
It’s not all the fault of the auditors. Ultimately, it’s up to the board. Disclosure isn’t a matter of meeting a test or ticking a box. Disclosure is an attitude. A company decides it is going to keep investors informed or not.
Disclosure failures have been at the heart of spectacular corporate failures, from Enron nearly a decade ago, to Lehman Brothers in 2008, and it’s again in focus in the aftermath of Facebook’s bungled IPO. There, Facebook filed a revised prospectus with a vague statement about user growth was outpacing advertising – an oblique way of saying its revenue growth was slowing.
Did the SEC filing by Facebook meet the legal requirement to disclose a material fact? Probably. (Although that question seems headed for the courts.) Was the statement sufficient to inform investors about the true state of Facebook’s profit outlook? No, it wasn’t.
The adequacy of J.P. Morgan’s disclosures has also been questioned following its $2 billion trading loss from a complex hedging strategy.
Ultimately, the decision to make a disclosure comes down to management and the board and whether they want to state the facts openly or hide behind obscure accounting practices.
I know in which company I’d want to invest.