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Public Companies SEC action addresses corporate accounting practices

On July 18, in the latest crackdown on accounting tricks, the Securities and Exchange Commission (SEC) announced that it had obtained consensual judgments in civil and criminal cases against American Bank Note Corp. (ABN), a subsidiary, a customer, and executives of all three.

The judgments included corporate and individual defendants and involved criminal guilty pleas, civil injunctions, monetary fines and prohibitions against individuals serving as officers or directors of public companies.

Management had employed a number of accounting gimmicks, including a classic “ship and hold” transaction to inflate the earnings of a subsidiary in preparation for its spin-off in a registered public offering.

The independent auditors missed the fraudulent accounting because they were provided with false assurances by management and false confirmations by a customer.

The result was a ruined company.

The fraudulent transactions occurred in 1997 and 1998. The company has not been able to file a 10-Q or 10-K since the problems were discovered. Its stock, which traded in the $6 range before the problems were discovered, is now essentially worthless.

Why did the oversight of the board not catch these problems before they destroyed the company? What can boards do to protect themselves and shareholders against dishonest management?

In the SEC’s “Current Issues and Rulemaking Projects” released June 21, 1999, one of the accounting issues highlighted was “initiatives to address earnings management.”

Earnings management and concealment of underperforming lines of business have been the subjects of numerous speeches and widely publicized actions taken by the SEC against public companies.


– Report Calls For Experience

In a speech on Nov. 5, 1999, at the 10th annual Conference on Financial Reporting, SEC Chief Accountant Lynn Turner noted that the level of visibility resulting from the broad availability of information on the Internet has created even more pressure on management to meet forecasts.

He strongly criticized those who meet forecasts by using accounting tricks to manage earnings. He called for greater professionalism on the part of boards of directors and independent auditors.

A blue ribbon committee co-sponsored by the New York Stock Exchange and the National Association of Securities Dealers was formed in 1998. Its members included individuals from the NYSE and Nasdaq and legal and accounting professionals. Its purpose was to study and make recommendations about how to make audit committees more effective.

The committee issued its report in July 1999. Among its recommendations were that audit committees be comprised of a minimum number of independent directors having recommended that NYSE- and Nasdaq-listed companies be required to have audit committees with written charters and a minimum of three independent directors.

It also recommended the committee members be able to read and understand financial statements with at least one, by virtue of prior experience or training, having special expertise in finance and accounting.


– New SEC Ruling

The SEC and the investing public expect boards of directors, and particularly audit committees, to meet high standards for financial reporting. Audit committees are expected to be active, inquisitive and independent.

The SEC has used its regulatory power to adopt Rule 306 to Regulation S-K. This rule requires audit committees to make a report to shareholders in any proxy statement involving the election of directors. This report must disclose what action the committee has taken with regard to four specific matters


including:

o Discussions with internal auditors;

o Discussions with independent auditors;

o Determination of independence of independent auditors; and

o Recommending to the board of directors inclusion of the company’s audited financial statements in the company’s annual report on Form 10-K.

By placing the spotlight of public attention on the “watchdog” role of audit committees, the SEC has forced them to become more active, inquisitive and independent than in the past. This should also make them more effective.


– Action Plan

The following, based on remarks given March 10, 2001, by Turner and on the recommendations of the blue ribbon committee, are essential elements of an action plan for an effective audit committee:

o Charter. The committee charter should give it broad power to take the steps it deems necessary to perform its role effectively. This should include the power to deal directly with any level of the company and to hire outside experts.

o Independence. All members of the committee should be independent of personal, social, or business ties with the company and its management.

o Due diligence and documentation. The committee should exercise oversight on the company’s information gathering and reporting processes by reviewing the company’s related policies, practices and procedures, including internal audit procedures, with the company’s chief financial officer, internal auditor and independent auditor.

o Discuss audit committee role. The committee should discuss with the chief financial officer, the internal auditor, and the independent auditor the role the committee will play in an unbiased, robust examination of the numbers to assure their credibility and integrity.

o Clear lines of communication with internal auditor. Studies show that financial frauds frequently involve internal controls being overridden by the chief executive officer or chief financial officer. The line of reporting from the internal auditor should be directly to the committee.

o Clear lines of communication with independent auditor. The committee should insist on being “in the loop” on financial reporting issues involving judgment.

o Diligent and capable committee membership. Members have to have sufficient experience in financial reporting matters to be able to understand financial statements and the accounting concepts that underlie them.

Lloyd is a former public company audit committee chairman, and currently with the Exchange Act Reporting and Compliance Group of Higgs, Fletcher & Mack LLP, San Diego.

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