Building better boards
BY RoBeRt C. Pozen
Although the financial crisis spawned numerous lawsuits, none alleged any significant
SOX compliance failures by boards of directors or their audit committees.
As required by SOX and related Securities
and Exchange Commission rules, most of the
directors of these institutions were independent. Management regularly assessed their
internal controls, and these assessments were
attested to by their external auditors. In 2007,
none of the major institutions that later came
to the brink of insolvency reported material
weaknesses in internal controls.
Their audit committees were composed
entirely of independent directors, who made
sure that their external auditors were truly
independent. The committees regularly received a list of significant accounting policies
from the external auditors. Committee members also met in executive session with the
company’s external and internal auditors.
So, what did we learn about corporate governance from the financial crisis?
In my view, the procedures mandated by
SOX for audit committees are not focused on
the key items, and the traditional model of a
board of directors is not effective for a large,
complex corporation. In both areas, we need
a new approach.
During the financial crisis, many boards of directors showed
that they did not fully understand the risks that their institutions
were taking. Did this failure of board oversight occur because
the directors did not comply with the governance provisions of
the Sarbanes-oxley Act?
The financial crisis revealed several areas for improvement
This comparative analysis should cover,
for example, revenue recognition, warranty
obligations, retirement plan obligations, tax
reserves, and valuation of goodwill or other
intangibles. It has been my experience that
some of the differences among companies
are due to differences in how they run their
businesses, but others represent accounting
judgments that the audit committee members should fully understand.
All these pieces of information should be
sent to the audit committee at least one week
before the committee meets. During that
week, the chairman of the audit committee
should informally discuss with the external
auditor and the company’s chief financial
officer any specific issues raised by this information, as well as other “close calls” embodied in the company’s financial reports.
If these suggestions are followed, the members of the audit committee will be less likely
to be overwhelmed by the documents sent to
them. Instead, they will be focused on the key
issues in reviewing whether the company’s
financial reports provide investors with a materially accurate and complete picture of its
The members of audit committees are deluged with massive amounts of complex in-
Robert C. Pozen is chairman emeritus of
MFS Investment Management, and also
serves as a senior lecturer at the Harvard
Business School and a senior research
fellow at the Brookings Institution. He
served on President Bush’s Commission to
Strengthen Social Security and was secretary of economic affairs for Massachusetts
Governor Mitt Romney.
formation — financial statements, technical
notes to these statements and lengthy SEC
filings including these statements. No matter
how intelligent audit committee members
are, they cannot easily pick out from this mass
of data the key judgments made by management and the external auditors in preparing
all these documents. To be blunt, most audit
committee members know what they are
told by management about the company’s
financial situation. To paraphrase Donald
Rumsfeld, the outside directors do not know
what they do not know.
To become more effective, audit committee members should insist on receiving
three specific pieces of information from
the company’s external auditors. First, the
external auditors should highlight any set of
transactions, such as sale-leasebacks or tax-motivated deals, that occur repeatedly at the
end of quarters or financial years. Although
it is reasonable to engage in one specially
designed transaction in response to a particular set of problems, it is more suspicious
if similar transactions occur frequently near
the end of a reporting period.
Second, the auditors should identify any
material item where the accounting literature allows management to choose between
alternative methods of presentation (e.g., the
direct versus indirect method of presenting
operating cash flows on the statement of cash
flows, or the option to measure certain financial assets and liabilities at fair value). The
company should supply the audit committee
members with a clear explanation of why it
chose the alternative it did.
Third, and perhaps most important, the
auditors each year should provide the audit
committee with a comparison of the company and its four or five main competitors with
respect to significant accounting policies
— those with material financial effects and
involving significant matters of judgment.
More fundamentally, we need to change the
experience, commitment and size of corporate boards of large, complex companies.
Many boards have directors without much
experience in the actual line of business of
the company. For example, of the 16 directors of Citigroup in 2006, only one had ever
worked for a financial services company.
While every board needs a few generalists,
together with an audit expert, the bulk of
board members should have worked in the
same industry as the company. This is the
best way to make sure that directors can truly
comprehend the operations and challenges
of a multinational company.
As a practical matter, directors from the
same industry are going to be retired executives. At that stage in their career, they no longer have the conflicts of interest that would
inevitably arise with sitting executives from
competitor companies. They would also have
the ability to spend more time on board mat-
See BoaRdS on
GASB PROPOSES HEDGE
NORWALK, CONN. — The Governmental Accounting Standards Board has proposed
guidance on how to apply the accounting
standards when a hedging derivative is
terminated for a government entity.
The proposed guidance comes in
the form of an exposure draft,
Derivative Instruments: Application of Hedge
Accounting Termination Provisions (an
amendment of GASB Statement No. 53).
GASB Statement No. 53 provides for
the use of hedge accounting for derivatives that are effective hedges. Hedge
accounting entails reporting fair value
changes of a hedging derivative as either
deferred inflows or deferred outflows of
resources, rather than recognizing those
changes in investment income. Statement
53 requires that hedge accounting cease,
and all accumulated deferred amounts
be reported in investment income, when
a hedging derivative is terminated. Under
Statement 53, questions have arisen
regarding situations where a government
has entered into a hedging interest rate
swap or a hedging commodity swap
and the swap counterparty or the swap
counterparty’s credit support provider
commits or experiences either an act of
default or a termination event as both are
described in the swap agreement.
When a swap counterparty or a swap
counterparty’s credit support provider is
replaced through an assignment or an in-substance assignment, GASB concluded
that the government’s economic position
remains unchanged. Therefore, the board
is proposing that when certain conditions
are met, the use of hedge accounting
should not be terminated.
The provisions of the proposed statement are limited to when a swap represents a liability of a government, the
replacement of the counterparty or credit
support provider meets the criteria of an
assignment or in-substance assignment,
and other swap terms are unchanged.
The provisions of this proposed statement would be effective for financial
statements for periods beginning after
June 15, 2011. Earlier application would
be encouraged. The deadline for comments on the exposure draft is April 15.