When Technical Compliance Doesn't Comply With the Spirit of GAAP
In the wake of Lehman Brother's collapse in 2008, shareholders filed lawsuits against Lehman and its auditor, Ernst & Young. The suits against Lehman allege that the company materially misrepresented its financial position. The suits against E&Y allege that the auditor, at a minimum, turned a blind eye to Lehman's misleading financial reporting. Lehman's alleged misdeeds were due to its use of loopholes to obscure its true financial picture from its shareholders.
Four interesting points came out during the recent court proceedings:
- Lehman's use of accounting loopholes was technically compliant with Generally Accepted Accounting Principles (GAAP).
- Lehman may have violated the spirit of GAAP by allegedly using these loopholes to mislead investors.
- Due to the lack of evidence that E&Y was aware that Lehman's accounting might have misled investors, the court dismissed the claims against E&Y's 2007 audit.
- Due to E&Y's awareness of whistle-blower allegations in its 2008 audit, the court affirmed the claims against its 2008 audit.
Would closing current accounting rule loopholes and audit gaps prevent such violations in the future?
Maybe not.
Under the Sarbanes-Oxley Law of 2002, the Securities and Exchange Commission (SEC)'s responsibility was, in part, to close the loopholes that had allowed public companies to mislead investors. The PCAOB's responsibility, in part, was to close audit gaps that had allowed company misrepresentations to pass through audits without notice. Clearly, these efforts have not been completely successful. Perhaps a specific accounting rule mandating compliance with the spirit of GAAP would be more useful. Such a broad-based rule would prevent companies or their auditors from escaping though the loopholes of the current accounting and auditing rules.
Substance over form
The concept of substance over form is the spirit of GAAP.
A company's financial reporting should reflect the true substance (i.e. the business purpose) of its operational and financial transactions rather than the technical accounting form of these operations and transactions. Investors need and expect financial reporting in the spirit of GAAP – an accurate depiction of the company's business performance.
So what rule governs the spirit of GAAP?
The principle behind all of the accounting rules.
The Financial Standards Accounting Board (FASB) establishes GAAP accounting rules and its guiding principles are found in the FASB Concept Statements. FASB Concept 2 specifically discusses "substance over form", stating that all of the accounting rules are designed to ensure substance over form reporting. Given this implied principle, Concept 2 determined there was no need for any explicit "substance over form" rule. Perhaps, however, there is a need for an explicit rule.
Over the past decade, we have witnessed many companies that have used loopholes and technical GAAP compliance to misrepresent their true financial picture to investors, thereby obviating the intent of the accounting rules. Given these practices, establishing an explicit rule requiring substance over form reporting would eliminate some of the wiggle room for misleading investors.
Whistle-Blower Allegations
Similar rules should be established for whistle-blower allegations. Right, wrong, good, bad – whistle-blowers can help or hurt a company. They may be the red flag of substance over form transgressions. In all cases, these allegations should not be ignored by management or the auditors.
In my securities litigation financial consulting work, I have seen internal communications from whistle-blowers to company hot lines, supervisors, and others in their attempts to notify the company of potential wrongdoing. Unfortunately, these whistleblowers' allegations were often dismissed as being just the complaints of disgruntled employees. Resultantly the boards of directors were not aware of these claims until they came out during the litigation.
Any whistleblower allegation, whether the auditors or management thinks it is worthy or not, should be brought to the attention of the audit committee and thoroughly reviewed and investigated. The specific whistle-blower allegation may not prove worthy or correct; however, the claim may be onto something that should be explored.
Why is this important?
Whistleblower allegations may be the tip of the iceberg.
In my experience, whistleblower claims often end up strikingly similar to financial statement fraud allegations brought against companies in securities litigation cases. Therefore, it would be wise to require that any whistleblower allegation be brought not only to the attention of management but also to others. Specifically corporate counsel, audit committees, and boards of directors should be informed of these allegations.
What's to be done?
Empowering the spirit of GAAP
Strengthening the principle of substance over form and establishing rules and procedures for vigorously reviewing any whistle-blower allegations would provide some strong first measures to prevent companies from bypassing the spirit of GAAP. Shareholders and the investing public deserve and expect this of public companies and their auditors.
Alice Hilton is the President of A B Hilton & Associates LLC, a financial services firm helping clients navigate an array of financial tranactions, litigation, forensic accounting and fraud investigations.