It makes no sense to abandon the proverbial long hard look the board, CEO and senior management should take of all operations under their watch, for the sake of ‘simplifying’ accounting procedures, or keeping some of assumed exposure out of public eye. What all opponents of rigorous accounting rules should appre- ciate is that those entrusted with governance are personally accountable for obtained results: Good or bad.
Precisely for this reason, Chapter 1 presented a short but comprehensive list of recent scams, from Enron and WorldCom to Parmalat, which boomeranged and hit CEOs and their immediate assistants on the head. Daewoo, the Korean con- glomerate, provides another example of management irresponsibility by exploit- ing loopholes in:
● Accounting systems, and
● Financial reporting rules.
In 1999, the high-flying Daewoo Group, the South Korean chaebol, collapsed with debts of $80 billion. Mid-2005, after running for six years as a fugitive, Kim Woo-choong, the former founder, animator, and CEO of Daewoo, returned home to South Korea to face arrest. He has been accused, among other things, of inflat- ing the group’s assets by $41 billion. Daewoo once employed 200 000 people worldwide and had sales of $60 billion.
Chief executives who are wrong-doers are not the only parties facing penalties and possible prison terms. The long hand of the law has now reached the for- merly exclusive club of board member. Company directors therefore should be personally interested in analytical, timely, and accurate:
● Financial accounting, and
● Management accounting which provides advance notice of impending dis- aster (see also Chapter 15 on real-time management reports, Chapter 16 on interval control, and Chapter 17 on the Audit Committee).
A severe blow to the idea of a secure and unchallengeable director’s seat was delivered in January 2004 with the announcements that ten former directors from each of two big firms, WorldCom and Enron, had agreed to pay a collective
$18 million and $13 million, respectively, of their own money. Behind these
settlements is the desire to tie up lawsuits launched by enraged shareholders against:
● Board members, and
● The firms which were supposed to have them under their watch.
While directors have often been sued by shareholders, these settlements are almost unprecedented. Moreover, other board members are currently the targets of high-profile lawsuits. In the past, shareholders’ and regulators’ claims against board members were covered by directors’ liability insurance. This no longer seems to be enough, and therefore the payments agreed by the WorldCom and Enron directors sent a warning as well as thrill of fear through boardrooms.
Whether an insurance company or individual directors themselves pay for dam- ages, a major question which arises when a company and its directors are sued for mismanagement or fraud is one of personal accountability. Each year, America’s biggest firms spend a few million dollars each on premiums to cover the directors and officers in case disgruntled shareholders, employees or regula- tors take them to court, but:
● The amount of money at risk rises fast, and
● Rather than being reactive depending on an insurance, it is much better to be proactive and in charge of the situation, through fair value accounting.
During the first quarter of 2003 claims worth more than $1 billion were paid by, or came due from, insurers who wrote coverage for directors and officers (D&O).
Now directors depending on reactive approaches must become used to opening their own wallets in order to pay for damages beyond what insurers would cover.
Notice that in the cases of Enron and WorldCom insurers of the scandal-shattered companies are expected to pay out the bulk of the money:
● $36 million for WorldCom
● $155 million for Enron.
What ten former non-executive directors of WorldCom agreed to settle is in addi- tion to insurance. The $18 million will come from their own personal wealth, though they neither admitted nor denied wrong-doing. Some estimates suggest this is equivalent to 20% of their personal assets, leaving aside their principal homes and pensions. The same is true of ten of Enron’s former directors, who will cough up $13 million – a disgorgement of insider-trading gains, plaintiffs say.9
It comes as no surprise that these settlements have sparked a hot debate about whether it will now get harder to find qualified directors for company boards.
Also, whether the two settlements will embolden America’s class-action lawyers to redouble their efforts – till tort legislation is revamped, which does not seem to be around the corner.10According to some estimates, in America alone plaintiffs are seeking $60 billionto $80 billionin class-action suits that are yet to be settled.
Independent directors play a vital role in company management, but also in its mismanagement. Therefore, institutional investors are increasingly interested in seeing officers and directors considered to be malefactors make due financial contributions out of their own pockets.
Insurance should be a matter of last resort, rather than one of blind reliance.
Moreover, for insurance companies, too, the rise in the number and size of law- suits means that rates for D&O coverage will go up, even if a couple of years ago (in 2003) they fell by 10%, because of tough competition. Start-up insurers in America and Bermuda have rushed to provide D&O cover and cut the coverage prices. But is this a viable solution?
In conclusion, no matter what different IFRS may be saying, the best way to solve a great problem is to treat it boldly as a whole, to go to the root, and settle its solu- tion upon a sound foundation. In business, the sound foundation upon which top management decisions can be based is reliable and timely financial and opera- tional information. This is precisely what IFRS and US GAAP aim to provide.
Notes
1 Robert J. Schoenberg, Geneen, W.W. Norton, New York, 1985.
2 EIR, 17 October 1997.
3 The Accountant, www.lafferty.com, October 2004.
4 Schoenberg, Geneen.
5 The Economist, 13 August 2005.
6 D.N. Chorafas, Rocket Scientists in Banking, Lafferty Publications, London and Dublin, 1995.
7 D.N. Chorafas, The Management of Equity Investments, Butterworth-Heinemann, London, 2005.
8 D.N. Chorafas, Economic Capital Allocation with Basel II: Cost and Benefit Analysis, Butterworth-Heinemann, London and Boston, 2004.
9 The Economist, 15 January 2005.
10 D.N. Chorafas, Operational Risk Control with Basel II: Basic Principles and Capital Requirements, Butterworth-Heinemann, Oxford and Boston, 2004.
11
Business Ethics Add Value to Financial Disclosures
1. Introduction
Chapter 10 has brought to the reader’s attention that accountability for good cor- porate governance squarely falls on the shoulders of senior management. In prac- tically every jurisdiction, the top of the organizational pyramid is the party ultimately responsible for reliable financial reporting. The Basel Committee on Banking Supervision says that responsibility for financial reporting may also rest with the board of directors1– who should be the first to appreciate that honesty is the best policy.
Paraphrasing the old Roman dictum about Caesar’s wife, the members of the board, CEO, and senior executives should not only be ethical people, but also should be seen as being so. Ethics in business is not the past but the future, and it is destroyed through creative accountingpractices.
The reasons for creative accounting are well known, and all of them are coun- terproductive (see section 2). It is the directors’ and CEO’s responsibility to ensure that such practices are alien within the organization under their watch.
Legislation helps in bringing a sense of accountability, an example being the 2002 Sarbanes–Oxley Act in the United States which made the CEO and chief financial officer (CFO) personally responsible for the accuracy of what is written in the company’s financial statement (see section 3).
Organizations are comprised of people, and it is a human trait to boast more than one has or does. But directors, the CEO and CFO should know where the brakes are. Even with an objective and accurate presentation of financial infor- mation in the consolidated quarterly and annual reports, inference about a company’s worth and financial staying power is not an easy matter. As far as equity valuation is concerned, the analyst’s work is very similar to that of the archaeologist.
● The archaeologist tries to make inferences and reconstruct a civilization through its surviving evidence.
To obtain some information on which to base his or her hypotheses, the archae- ologist studies the shape and nature of a container through fragments which may have decayed, or may be insufficient. Yet, this practically is all there is available in terms of evidence in archaeology. Quite similarly,
● The financial analyst looks at past accounts which may be obscure, or alto- gether unreliable, because of ‘creative’ ways of financial reporting.
More recently, the analyst also looks at the quality and ethics of corporate gov- ernance for clues on what went right or wrong with the accounts. The storm which shook up Tyco started when Wall Street got wind that Denis Kozlowski, its CEO, had cheated the State of New York on taxes due for artwork he had pur- chased, by shipping the wares to Maine and, through a U-turn, bringing back the art to his residence in New York City.
In a much broader sense, events such as the collapse of energy trader Enron, cable operator Adelphia Communications, international carrier Global Crossing, and the second largest US long-distance carrier WorldCom, or for that matter Italy’s Parmalat, have cast doubt on the reliability of accounting practices. Many parties have come under fire:
● Accountants
● Auditors
● Rating agencies
● Financial analysts, and
● The entities’ own top management.
These and many other meltdowns, have directed new attention to the ills of per- sonal greed, lousy accounts, and inadequate surveillance. The consequence has been a loss of trust that needs to be won back, and this will not be easy. A long list of scams has demonstrated that company CEOs and CFOs can manipulate accounts to suit their own finances, rather than shareholder value or the interest of their employees and of the general public. Proof has been provided that:
● Accounting standards become easily the subject of manipulation.
● Hence the need for legislation to see to it that prison terms beckon for wrong-doers.
Even investors have attracted criticism for accepting published corporate profit figures at face value. Over-reliance on audited financial statements, and on cred- itor protection acts, ended by emptying many portfolios of their wealth, hitting particularly hard those who can least afford to lose their hard-won money.
Everybody can profit from ethical financial reporting practices and the purging of creative accounting gimmicks.