Contributors to corporate integrity: The CFO, internal/external auditors and audit committees

This is a sequel to the previous week’s thoughts on ‘Corporate Integrity and the evolving Hertz story’. 

Former Tesco CEO Chris Bush

Former Hertz CFO Elyse Douglas

Former Hertz CEO Mark Frissora

Feeders to integrity can improve

Let me elaborate on what I referred to as contributors last week. They are the Chief Financial Officer and his team, the in house-Chief Internal Auditor or the Outsourced Independent Internal Auditors, the Audit Committee and the External Auditors. The above-mentioned roles are what I call feeders to integrity. 

My experience in each of these roles, prompts me to say that the scope, approach, methodology, coverage and effectiveness of all these roles need constant review and upgrading. If not, there will be breaches. I say this since I have performed or assessed the performance of, and based thereon, trained and capacity built persons in such positions, or as Chair of Independent Audit Committees and as a consumer of internal and external audit services even replaced certain providers. This is not a popular move when the parties you replace are members of your profession. 

Adding value is possible

As a learning outcome for practitioners, in this column, or in a follow up, I will elaborate on several instances where, while serving as Chair of Audit Committees, I was able to substantially improve the effectiveness of these components, by adding value, through a process of going beyond the traditional approaches, reaching out beyond the often inadequate minimum governance structures and compliance requirements of scope, coverage and frequency of meetings, that are published in Audit Committee Charters or the multiplicity of Corporate Governance Codes from the Big 4, professional institutes or the OECD – to name a few. 

Of course this proactive approach required in house accounting and finance professionals, internal auditors, external auditors, legal counsel, and board secretaries, to be far more alert and on the ball, than they had hitherto been. Many have told me that it was “pressure” at the beginning but that later it was a “pleasure” since they became more confident, secure, moved up the “value adding” chain and were respected, better recognised, promoted, and rewarded. 

The role of the CFO

The role of record keeping, accounting, reporting and disclosure, and the internal controls, systems and procedures, that lend itself to these functions, are the primary responsibility of the Chief Financial Officer (CFO). The CFO ensures that financial statements are made available for the review of internal and external auditors, audit committees, and boards of directors. CFOs have a responsibility to present monthly, quarterly, semi-annual, financial statements to the Audit Committee who reviews corrects, amends and then submits these to audit committee and board meetings. It is an inherent expectation that the CFO complies with fundamental principles of accounting and compliance with standards of accounting reporting and disclosure. It is in this context that the following are noteworthy. 

Hertz, moves headquarters – CFO Elyse Douglas resigns

In September 2013, Hertz Global Holdings Inc. had announced that Elyse Douglas, the chief financial officer, had decided to resign due to her inability, to relocate to the new corporate headquarters in Florida. She was to stay with the company through 31 December that year to assist in transitioning her responsibilities to her successor. Hertz announced that David J. Rosenberg, the chief financial officer of Hertz International, was to serve as the company’s CFO on an interim basis while candidates are considered. 

Mark Frissora – Hertz Chairman/CEO

Mark Frissora, Hertz chairman and chief executive officer, and many others had moved to Florida. Frissora, had referred to Elyse Douglas as a valued member of the Hertz senior management team since she assumed the CFO role in August 2007 and that her finance team had helped through the financial crisis in 2008-2009, to transform the company’s balance sheet in the aftermath of the recession and in key acquisitions including Donlen and Dollar Thrifty and the investment in China Auto Rental.

Elyse Douglas had stated: “Hertz has been a fantastic professional experience and it’s disappointing that I’m not able to join the senior team in Florida,” and that the company had “tremendous growth opportunities and has a great culture based on transparency and integrity. I look forward to watching Hertz capitalise on its strengths and new initiatives.” 

Hertz had promoted Douglas from Treasurer to CFO in 2007. In a 2012 interview with the CFO magazine, however she noted that treasury was “a specialised field and essentially a ‘support’ role with defined functions,” and that “becoming accustomed to having a high-level focus and relinquishing the need to know all of the details proved to be the biggest adjustment for me.”

Enter Thomas Kennedy – new CFO

The company recruited a new CFO, former Hilton Worldwide finance chief Thomas Kennedy. Kennedy was at the time of his appointment, apparently being paid a significant salary by two different companies. He had left Hilton two months before it went public and was to be paid $ 1.06 million annually for the next three years. At Hertz, his base salary was $ 660,000.

Hertz Audit Committee and the External Auditor

As discussed last week, Hertz agreed to pay $ 16 million to settle fraud and other charges brought by the Securities and Exchange Commission stemming from multiple company filings containing inaccurate financial statements and disclosures, from February 2012 through March 2014. In July 2015, Hertz restated its financial results for prior periods, identifying $ 235 million in previously reported pre-tax income based on treatment of items that were not consistent with generally accepted accounting principles (GAAP). There is very little discussion on the company’s audit committee that we in Sri Lanka, place considerable emphasis on. Hertz’s external auditor, PricewaterhouseCoopers, had given the company clean audit reports for these years.

Pressured corporate environment 

The SEC’s order found that the inaccurate reporting occurred in a “pressured corporate environment” that placed “improper emphasis on meeting internal budgets, business plans, and earnings estimates.” The SEC’s order required each Hertz respondent to cease and desist from further violations of the charged provisions, and requires Hertz Global to pay the $ 16 million penalty. An internal investigation by Hertz’s board concluded, “Frissora created a pressure-cooker work environment in which he leaned on subordinates to make inappropriate accounting decisions so the firm could hit its financial targets.” If it looked like Hertz might miss a financial milestone, Frissora would “berate subordinates who did not come up with “non-traditional accounting approaches” to fill the gaps between Hertz’s actual and expected performance.” Douglas and Zimmerman were sued for failing to report their boss’s pressure tactics, Hertz said in the complaint. 

Gross negligence and a $ 70 m in clawbacks

Hertz in a 25 March 2019 lawsuit, accused several former executives of pressuring employees to use fraudulent accounting techniques to inflate income and earnings in around 2014. Hertz maintained that, the restatement of $ 235 million “was triggered by the gross negligence and misconduct of Hertz’s senior executive officers” who set the wrong tone at the top and that ex-Chief Executive Officer Mark Frissora and other former senior managers should return at least $ 70 million of incentive compensation for their roles in the accounting scandal. 

Hertz’s policy and Sarbanes-Oxley

According to a regulatory filing, Hertz policy “allows it to claw back compensation from any employee whose gross negligence, fraud or wilful misconduct contributed to a financial restatement.” Clawbacks though rarely used, are a powerful tool for companies seeking to punish executives for wrongdoing. It is reported that, they are made possible by the 2002 Sarbanes-Oxley Act, and have been used by firms including Wells Fargo & Co and JPMorgan Chase & Co to recoup hundreds of millions from ex-employees accused of malfeasance. Despite all these laws in the US the following are the legal outcomes. 

Refusal to return

Hertz had filed the lawsuit after Frissora, ex-CFO Elyse Douglas and Zimmerman refused to return incentive compensation tied to the erroneous results. In a statement, Frissora had said, “I strongly disagree with the allegations. I am proud of my record of integrity and transparency in business, and I am confident these claims will be shown to be untrue.” Hertz stock had fallen sharply in mid-2014 when the company disclosed it would have to restate results for the previous three years and cut its sales forecast. Frissora resigned that August amid pressure from investors, including billionaire activist Carl Icahn. The stock had plunged about 85% since then.

Former President Scott Sider

While Hertz also demanded that former president Scott Sider, of the rental-car unit in the Americas, repay incentive compensation he previously received, Sider sued the company in state court in Delaware after it refused to pay his legal bills related to the clawback. Time has not permitted me to research the outcome, or the present status of all these lawsuits.

A similar event in the UK – The Fiasco at Tesco

It was in the FT of 24 September, 2014, that I wrote in my column ‘The Thought Leadership Forum’ under the caption ‘The fiasco at Tesco, and value of accountants and independent interim limited scope engagements’. I will reproduce brief extracts of that article: Tesco, a FTSE 100 company, in August 2014, suspended four executives, including its UK Managing Director Chris Bush, after the supermarket overstated its half-year profit guidance by £ 250 m. The amount equated to almost a quarter of its expected profit for the period. It launched an investigation headed by Deloitte. A number of persons had been suspended from duty to facilitate the fullest and deepest investigation possible. Tesco also confirmed that there had been no Chief Financial Officer (CFO) at the group after its current CFO Laurie McIlwee left just over a week ago following his resignation in April. Marks and Spencer’s Chief Financial Officer (CFO) Alan Stewart was announced as McIlwee’s replacement in July, but was not due to join Tesco until that December. 

Accelerated recognition of income

On 29 August 2014 Tesco had said it expected its trading profit for the six months to 23 August to be about £ 1.1 b, lower than management had expected. In its later statement, Tesco said the profits overstatement was “principally due to the accelerated recognition of commercial income and delayed accrual of costs.” It also said some of the errors, which referred to its expected profits for the six months to 23 August was due to the timing of the accounting of payments between suppliers and Tesco. Lewis said this meant “an element of “expected revenue from its suppliers had been reported in the wrong time period. It’s about revenue received versus when the activity took place,” he added. Tesco said “an informed employee” had alerted the Board to the issue on Friday, and added it had already informed the UK’s financial regulator, the Financial Conduct Authority.

Tesco has been battling falling sales and a decline in its market share. As a result of the problem, Tesco has pushed back the release of its interim results to 23 October, from 1 October. Deloitte were to carry out its investigation with Freshfields, the group’s external legal advisers. Tesco’s auditors were PricewaterhouseCoopers. Shares in Tesco reached an 11-year low in August after the firm cut its full-year profit forecast to £ 2.4 b from £ 2.8 b. The supermarket group has been battling falling sales and a decline in its market share as discount chains such as Aldi and Lidl have gained in popularity. Previous chief executive Philip Clarke stood down in July after his attempts to revive Tesco’s fortunes through a £ 1 b turnaround plan failed.

It is useful that I recall what I stated in my 24 September 2014 article: 

Value of accountants

I have been articulating the value of inviting independent professionals/external auditors to perform reviews of interim financial statements, before they are released to the public. These are ordinarily undertaken as limited scope engagements, to add strength to, even a perceived to be robust, in house accounting and reporting infrastructure. 

Limited scope – non-opinion – engagements 

Having functioned as a Manager of Deloitte overseas while in my audit years, I had been exposed to a number of limited scope – non opinion – engagements which, have their own international standards of scope, approach, methodology and reporting and I learned that there clearly is a value addition to any organisation. On my return to the country, I articulated the merits of these services and the need to market such services, when I served as a Partner of PricewaterhouseCoopers in Sri Lanka.

A win-win for multiple stakeholders

Given that I was not in the External Audit profession, but in the Consulting/Advisory profession, and hence without any conflict of interest, I have mentioned in many fora that this is a respectable source of additional income for professional services firms, which they can re-invest in more substantive and firm wide, regional or international staff training, in information and communications technology, hardware and software and even incremental remuneration. 

I maintain of course that it is a win-win for both the client and the professional services firm for the reason that the client receives a higher degree of professional assurance on its interim financials and simultaneously on its in-house, accounting, reporting and disclosure infrastructure. Clearly the shareholder and the regulators, whether the SEC, CSE or in our jurisdiction, the Sri Lanka Accounting and Auditing Standards Monitoring Board, as well as investment advisors and analysts are also winners. 

Putting thoughts into practice – JK Hotels and Susantha Ratnayake

A few months after Susantha Ratnayake, took office as Chairman in 2006, having accepted his invitation to serve on the Board of John Keells Hotels PLC, somewhere in 2005, yes almost 15 years ago, I put this thought into practice as Chairman of its Audit Committee. I articulated the rationale for and the merits of a six or nine month external review. Neither JK Holdings PLC, whose Audit Committee was Chaired by Senior Chartered Accountant, Nihal Vitharana, nor any company within the Group had engaged external auditors to undertake such limited scope-non opinion work on interim financials. Thus it would have created precedent. 

The Executive Vice President, Leisure Group, fellow Chartered Accountant, Chandrika Perera, who I had worked with before, and knew her outstanding capability well, expressed discomfort. She light heartedly asked me whether “I was having a doubt about the capability of her team”, and said that my proposal would result in additional fees to Ernst & Young. I had to reassure her that I was only trying to strengthen her already strong elbows. JK Hotels were making losses; due to the war – I recall the 7-8 resorts made a loss of Rs. 500 million, while the then four Maldives properties made a profit of Rs. 300 million. I persevered in the interest of the group. There was a brief silence. Susantha as Chairman of the Board with a gesture of his hand, suggested that I be provided with the freedom to resource as I deemed fit, and supported the proposal. We thus proceeded to engage Ernst & Young to undertake the review of the interim financial statements, under terms of a limited scope engagement, at the middle of each year, and sometimes shifting to a nine month review, prior to release of the quarterly statements to the public. This practice, I gathered, was subsequently followed by many other sectors in the group. 

Conclusion

My point here, both with regard to Tesco as I said in September 2014, and with regard to Hertz, is that if they were listed in Sri Lanka, with our Chartered Accountants and progressive Chairpersons and Boards of Directors, both listed entities might have been exempted from the debacles they faced and the embarrassment with the regulators, shareholders, equity providers and all. 

Hertz Headquarters Florida