Numbers Pressure: In an article in its May 2006 issue, CFO Magazine reports the results of a survey of finance executives. Among other things, the survey participants were asked:

Do you ever feel pressure from your superiors to use aggressive accounting techniques to make results appear more favorable?

11 percent of public company participants and 23 percent of private company participants answered this question “Yes, ” meaning that they did feel pressure from superiors to use aggressive accounting. The article optimistically suggests that these results show that Sarbanes Oxley’s certification requirements are having a positive impact, because of the superior public company survey results. The glass-is-half-empty interpretation, by contrast, is that even in this day of heightened corporate scrutiny, some companies CEOs are still straining to leverage accounting to make their numbers. The private company survey results are particularly dispiriting. Corporate boards may also want to note the survey finding that 44% of the respondents believe that their CEO does not know as much about finance as he or she should.

Perhaps the CEOs Should Buy This Book: In light of the CFO Magazine survey’s results suggesting that some CEOs may lack of sufficient financial knowledge, it may be timely that the latest title in the “For Dummies” series is Sarbanes-Oxley for Dummies. Although the book favors simplicity of expression over depth of analysis, it is actually a pretty good resource. The book contains a number of useful appendices, including sample audit committee reports, etc., The book’s list of the “Ten Ways to Avoid Getting Sued or Criminally Prosecuted” probably would justify the book’s price for most corporate officials.

And Speaking of Sox…: An alert D & O Diary reader raises the interesting question whether the current wave of restatements arising from options backdating will lead to the first application of the forfeiture provisions of Section 304 of the Sarbanes-Oxley Act. Section 304 provides for officers’ forfeiture of incentive/bonus compensation in the event of restatements. Give that any restatements for options backdating would be due to a requirement to accurately present the officers’ compensation, there would be a certain symmetry in requiring the officers to return the compensation and stock profits to the company.

“Thompson Memo” Update: Readers as concerned as the D & O Diary is about the possibility that corporations seeking to avoid criminal prosecution by following the Thompson Memorandum might choose to terminate payment of employees’ attorney’s fees will want to read today’s post on The CorporateCounselnet blog.

The classic statement on the pitfalls of providing optimistic earnings guidance appeared in Warren Buffett’s Letter to Shareholders in the 2000 Berkshire Hathaway Annual Report (only an excerpt is reproduced here, but the entire Letter warrants reading, especially in light of subsequent events):

The problem arising from lofty predictions is not just that they spread unwarranted optimism. Even more troublesome is the fact that they corrode CEO behavior. Over the years, Charlie [Munger, Berkshire’s Vice Chairman] and I have observed many instances in which CEOs engaged in uneconomic operating maneuvers so that they could meet earnings targets they had announced. Worse still, after exhausting all that operating acrobatics would do, they sometimes played a wide variety of accounting games to “make the numbers.” These accounting shenanigans have a way of snowballing: Once a company moves earnings from one period to another, operating shortfalls that occur thereafter require it to engage in further accounting maneuvers that must be even more “heroic.” These can turn fudging into fraud. (More money, it has been noted, has been stolen with the point of a pen than at the point of a gun.)

Buffett didn’t exactly predict the wave of corporate scandals that came in the years immediately after he wrote these words, but he sure wasn’t surprised by it. He was prescient even if he wasn’t prophetic.

The recent corporate scandals have produced a changed atmosphere and led to changed corporate practices, including changed practices regarding earnings guidance . A 2006 survey conducted by the National Investor Relations Institute found that fewer and fewer companies are providing quarterly earnings and revenue guidance. Among the survey’s findings is that the number of companies providing earnings guidance declined to 66% from the 71% in the prior year’s survey (and down from 79% in the 2001 survey), and that only 56% of companies provide revenue guidance, down from 60% in the prior year. The survey also found that only 52% of companies were providing quarterly earnings guidance, down from 61% in the prior year. Among the prominent public companies that are declining to provide guidance are: Coca-Cola, AT&T, McDonald’s, Google, General Motors , Ford, Motorola, and Campbell Soup. A Wall Street Journal article discussing the 2006 NIRI survey appears here (via wsj.com, subscription required).

A thoughtful discussion of the issues surrounding earnings guidance appeared (via economist.com, subsciption required) in a recent issue of The Economist magazine. Among other things, the article presents data from an academic study showing that companies that actively guided met or beat analysts’ estimate more often that occasional or nonguiders, but that the active guiders grew more slowly than occasional or nonguiders. On the other hand, the article quoted a different academic study analyzing 76 companies that have ended quarterly guidance since 2000 and concluded that poor performers were more likely to reduce guidance, suggesting that “ending guidance can be a fig leaf for companies in trouble.” (While that certainly can’t be said of Berkshire or Google, it might be an accurate statement about GM or Ford).

One thing is for sure; more and more companies are deciding that the best way to avoid missing guidance is to avoid giving guidance. A detailed discussion of the pitfalls of earning guidance and analyst communications — and how to avoid them — can be found here.

Accounting Discipline

A May 4, 2006 article on CFO.com reports that a former accountant for a heart-disease research foundation was sentenced to two to six years in prison for embezzling more than $237,000 from the foundation. The accountant apparently used the embezzled funds to pay for the services of Lady Sage, a dominatrix. He also allegedly charged purchases at stores such as Leather Creations, Victoria’s Secret and Wicked Naughty Accessories. His attorney told the press that “It’s just one of those things. I guess it was a midlife crisis.” Apparently that explanation did not satisfy the accountant’s wife, who, according to the article, “was so angry that she refused to pay for [his] $10,000 bail.”

Well, it didn’t take long for my prediction in yesterday’s post — that we would be hearing more about options backdating — to be proven correct. Today’s Wall Street Journal has a front page article (via wsj.com, subscription required) reporting that United Health Group has warned that it may need to restate three years of financials because of “significant deficiencies” in how the company administered options grants. The article also reports that Brooks Automation will restate seven years of financial statements because it believes it recognized too little compensation expense for options granted to executives. The article is accompanied by a graphic entitled “Key Companies in Options Probes” describing options inquiries at seven companies. The article also states that the SEC has “ramped up its investigation” of options grants and that the SEC is “now conducting reviews of about 20 companies.”

Every day seems to bring fresh media outrage on the topic of executive compensation. Yesteday, the New York Times ran this article questioning executives’ personal use of corporate aircraft. (See a useful discussion of this article on the CorporateCounsel.net blog).

Among the more interesting media analyses on the topic of executive compensation is the series of articles that the Wall Street Journal has published on the topic of options backdating. The first article (via wsj.com, subscription required) in the series, entitled “The Perfect Payday,” appeared on March 18, 2006. The article reported an apparent (but statistically unlikely) pattern at several companies of options grants to senior executives dated just before a sharp rise in the share price, and at or near the bottom of a steep dip.

In a subsequent article (via wsj.com, subscription required) on May 6, 2006, the Journal reported that a number of the companies named in the original article have had (or will have) to restate prior year’s financials as a result of options backdating. The restatements were required because the restating companies have to record “additional noncash charges,” because accounting rules require companies to report an expense for grants of “in the money” options. The article also explained that companies that backdated options may face bills for unpaid income taxes because backdated options wouldn’t qualify for compensation-related tax deductions that may have already been taken.

This recent media attention follows an SEC inquiry looking into alleged options backdating that has been proceeding since November 2004 and that according to some media reports has involved more than a dozen companies. The SEC investigation has resulted in Analog Devices agreeing to pay a civil money penalty of $3 million in November 2005 . In addition, three senior officers at Mercury Interactive resigned in November 2005 and the company was delisted from NASDAQ after the SEC investigation uncovered backdated options grants.

Perhaps inevitably following the front page publicity of the issue in the Journal , the securities class action lawsuits raising option backdating allegations have begun to arrive. Since the March 18 Journal article, three of the seven companies identified by name in the Journal series of articles have been named in separate securities class action lawsuits raising allegations pertaining to alleged options backdating. The three companies named so far are Comverse Technology, Vitesse Semiconductor and United Health Group. In addition to these purported shareholder class actions, United Heath Group has also been sued in a separate purported class action raising substantially similar allegations on behalf of United Health Group employees in connection with their 401(k) plan. A detailed discussion of Comverse Technology’s recent woes, including separate shareholder derivative litigation that recently has been filed against the company in connection with these issues, appears at this post. (In addition to these three lawsuits, Mercury Interactive was named in an August 2005 securities class action complaint, but the complaint does not contain options backdating allegations.)

The alacrity with which the plaintiffs’ lawyers have jumped on this issue makes me wonder if the plainitffs’ bar will try to turn the options backdating story into”this year’s model”, along the lines of the successive litigation onslaughts we saw in the recent past following, for example, the bursting of the Internet bubble, the IPO laddering conflagration, the telecom industry collapse, the energy industry implosion, etc.

As the quotation below may suggest, the alleged practice of backdating options may not have been widespread. We can, however, be certain that we are going to be hearing a lot more from the media about executive compensation issues — and I expect that we will also be hearing more about options backdating. Whether or not additional companies will be named in shareholder lawsuits raising options backdating allegations of course remains to be seen.

Quotation of Note:

In the May 6 Journal article, commenting on how widespread options backdating may be, David Aboody, an associate professior at the Anderson School of Management at UCLA, said “It’s like stealing money. How many CEO’s steal money from their company?”

Each of the various published studies of the 2005 securities class actions has its own average settlement amount for 2005 securities class action settlements. The Cornerstone study reported an average 2005 securities class action settlement of $28.5 million, not including the WorldCom settlement. The NERA study reported an average settlement of $24 million, not including the WorldCom settlement. By contrast to these two reports, which are more or less in the same ballpark, the PricewaterhouseCoopers study reported an average settlement of $71.1mm, not including the WorldCom and Enron settlements.

The explanation for this difference can be found in the footnote 1 on page 18 of the PwC study, in which the authors state:

Settlement year is determined by the year the settlement is disclosed. Settlements listed for 2005 include some that were announced and/or preliminarily approved in 2005.

The PwC study’s use of the date of the settlement’s announcement contrasts with the NERA study’s and the Cornerstone’s study’s use of the date of the settlement approval. Because the PwC study uses the announcement date, it has included within the 2005 settlements a number of very large settlements that were announced but not yet approved in 2005. These other settlements include the $1.1 billion Royal Ahold settlement (announced in November 2005), the $2.5 billion AOL Time Warner settlement (announced in April 2005, preliminarily approved in September 2005, but not finally approved until February 2006), and the McKesson $960 million settlement.

One of the PwC’s study’s authors has confirmed this analysis to me.