Accounting-related class actions and regulatory enforcement cases increased in 2023 (see Cornerstone: Accounting Class Actions and Enforcement Cases Continue Their Upward Trend in this Update). This seems to suggest that accounting errors are becoming more common. In a recent blog post, Why Are Accounting Errors on the Rise at U.S. Public Companies?, proxy and corporate governance advisory firm Glass Lewis offers some reasons for financial reporting problems. Overburdened audit committees are one of the factors it identifies. The firm also makes clear that, despite the burdens and challenges audit committees face, it is prepared to recommend proxy votes against audit committee members who are not fulfilling their core duties.
Scope of the Problem
Glass Lewis notes that, since 2021, SEC enforcement actions related to issuer reporting, auditing, and accounting have increased from 70 cases in 2021 to more than 100 in 2023. Further, in the 2023 proxy season, financial reporting concerns, particularly those relating to material weaknesses and restatements, led Glass Lewis to make adverse proxy voting recommendations 2.5 times more frequently than in the 2022 season. Glass Lewis states that the increase in adverse voting recommendations based on financial reporting issues “reflects a market environment in which less established issuers are still developing strong internal controls – however, these errors are not only affecting less established issuers.” The blog post also notes that, in announcing its 2023 enforcement results, “the SEC highlighted a wide range of alleged misconduct at a wide range of issuers, including many companies that only recently went public by way of SPAC mergers *** as well as many more established companies ***.”
Drivers of Financial Reporting Issues
Glass Lewis cites three causes for increasing financial reporting problems.
SPAC and IPO Boom. During 2020 and 2021, there was an explosion in new listings stemming from the popularity of special purpose acquisition companies (SPACs) and initial public offerings (IPOs). According to Glass Lewis, “Many of these less established public companies may have less experience dealing with the rigor of public company financial reporting, even compared to typical newly-public issuers, since the SPAC process allows companies to bypass some of the regulatory obstacles involved in an IPO.” Moreover, in April 2021, the SEC staff issued guidance concerning accounting for SPAC warrants. This guidance resulted in many restatements.
Lack of Qualified Accountants. Glass Lewis also points to a shortage of qualified accounting personnel. As discussed in the blog post, some companies have publicly attributed material weaknesses to their inability to hire sufficient qualified staff. This problem may not be solved rapidly.
“In general, companies looking to fill vacant accounting positions must face a difficult labor market where qualified candidates are increasingly scarce. The Wall Street Journal reported that some universities are reporting ‘double-digit’ percentage declines in accounting degree enrollments, with U.S. Census Bureau data suggesting that accountant salaries have failed to outpace inflation in recent years. Perhaps not unrelatedly, hundreds of thousands of existing accountants have sought career changes in more lucrative sectors.”
(Regarding the relationship between material weaknesses and the accountant shortage, see Material Weaknesses are Increasing and an Accountant Shortage May Be to Blame, August-September 2023 Update.)
Increasing Audit Committee Oversight Responsibilities. Glass Lewis also suggests that the growing scope of the audit committee’s responsibilities may be compromising the ability of audit committees to perform their core financial reporting oversight responsibilities. Cybersecurity and ESG disclosure and reporting are examples of complex new challenges that have in many cases been placed under audit committee oversight. Glass Lewis observes that this “trend is understandable – the audit committee’s role in overseeing risk factors lends to its ability to manage cybersecurity and ESG.” However, broadened audit committee mandates may come at a price, and “boards and investors should be mindful that, absent additional resources commensurate with the increased scope, these new areas of oversight might also divert audit committee members’ attention from their core responsibilities.” Glass Lewis notes that the PCAOB’s NOCLAR proposal could exacerbate this problem. That proposal would expand the auditor’s responsibility to detect and report non-compliance with a wide range of laws and regulations. See PCAOB Proposes to Expand Auditor Responsibility for Financial Statement Fairness and for Legal Compliance, May-June 2023 Update. “The expanded definition [of the auditor’s responsibility to report non-compliance to the audit committee] included in the amendments might also place further strain on audit committees in their role of evaluating, selecting and rotating company auditors, and reshape the relationship between auditors and audit committees.”
Impact on Proxy Voting Recommendations
Glass Lewis does not foresee an early end to the increase in accounting and related reporting issues: “We anticipate that present developments in corporate accounting, including de-SPAC companies, accounting personnel shortages and expanding audit committee responsibilities, will continue to influence the volume of financial reporting related concerns we review in our research.” When financial reporting errors or material weaknesses in internal control over financial reporting (ICFR) occur, Glass Lewis’s Benchmark Policy on proxy voting focuses on how the audit committee responds.
As to material ICFR weaknesses, “the policy focuses on audit committees that fail to provide material updates to their remediation plans when a material weakness has been ongoing for more than one year, and will consider recommending against audit committee members in cases where this disclosure has not been provided or the material weakness has not been remediated on a timely basis.”
As to restatements, the policy predominantly focuses on the materiality of the changes in key financial statement line items. “Where such adjustments exceed relevant thresholds, or where fraud or insider manipulation is involved, the Benchmark Policy will also consider recommending against audit committee members.”
Comment: The Glass Lewis post is a reminder that audit committees need to be careful that new responsibilities like ESG and cybersecurity oversight don’t distract them from their core mission of financial reporting oversight. Glass Lewis recognizes that the full board and management have a responsibility to protect the audit committee from being overwhelmed. It makes this recommendation:
“It may be useful for all public companies, regardless of how well established, to review their board’s structure and the breakdown of responsibilities assigned to different committees. In particular, boards need to meet increasing investor expectations regarding the oversight of subjects such as cybersecurity and ESG, without undermining their effectiveness in more traditional areas of oversight. With a range of tools at their disposal, including increases in board size, formation of new committees, or more frequent hiring of specialized consultants, we will continue to closely monitor how companies approach this challenge — and how investors respond.”
Audit committees should reflect on whether they are in a position to discharge all of the responsibilities that have been assigned to them without compromising their primary financial reporting oversight function and be prepared to have candid discussions with the full board about steps that can be taken to maintain their effectiveness.
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