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Doug Raymond
Partner
Drinker Biddle & Reath LLP

Neither an Auditor nor an Editor Be

How directors should approach their role in reviewing periodic reports.

By Doug Raymond

It is no surprise that now, more than ever, regulators and investors are more carefully scrutinizing the accuracy and adequacy of the SEC filings made by public companies -- and in particular their annual and quarterly reports. And while many believe that the number of companies restating their financial statements may have peaked last year, there are nonetheless a host of disclosure procedures and requirements that are now mandated for filings. These requirements are intended not just to minimize future misstatements, but also to improve the quality of the information conveyed.

The directors, particularly those on the audit committee, have oversight responsibilities for these reports. Companies must disclose whether or not the audit committee members have reviewed the audited annual financial statements and discussed them with management and the outside auditors.

In the case of NYSE-listed issuers, audit committee members must carry out these reviews and discussions with respect to both the financial statements and Management’s Discussion and Analysis (MD&A) included in each quarterly and annual report. Of course, many companies impose additional obligations on the audit committee members to review the SEC filings before they are finalized.

Against this background, how should the audit committee members -- and, more generally, the directors -- approach these filings?

When reviewing a draft SEC filing or similar document, the director’s role is not that of an auditor or editor. Let the auditors dissect the numbers, and let someone else worry about the grammar. Of course, if there is any suggestion that something is amiss, a director must make inquiry.

Absent a red flag, however, a director should be able to rely on management and assume the accuracy and reliability of the information in the report. Rather, the director should focus on the substance and listen carefully for the tone and the perspective reflected in the report.

The SEC, among others, believes that periodic reports, particularly the MD&A, should reflect management’s “unique perspective.” This enables investors to see the company through the eyes of management and provides the context for analyzing the company’s financial information. It lets investors understand the quality of, and potential changes in, the company’s earnings, cash flows, and overall financial condition. According to the SEC, the MD&A should reflect what management thinks is happening, and why it is happening -- particularly regarding trends, uncertainties, and contingencies that may cause reported financial information not to be indicative of future results.

Too often, the individuals preparing a periodic report view it as a template to be updated quarterly or annually by the rote process of plugging in new numbers and calculating percentage changes. This is sometimes seen as a “safe” approach -- if the text was acceptable to the attorneys and regulators before, why make changes?

Ironically, this approach results in a report that is less likely to satisfy the company’s disclosure obligations because it may fail to reflect the current state of the company and the implications of current trends and uncertainties. (We have seen this process lead to the embarrassing situation in which a report stated that numbers had declined since the previous period although the numbers had in fact actually increased -- this because the person preparing the report changed the numbers but did not “catch” the need to change the surrounding text.)

The regular discussions that the audit committee holds with management, the internal auditors and external auditors, along with the committee’s own discussions and its participation in setting and reviewing the company’s accounting policies, should give audit committee members a good basis for assessing whether the report sufficiently communicates the material issues facing the company today and in the future. Even directors who are not on the audit committee should have enough familiarity with the company to evaluate the substance and tone of the report.

Questions to keep in mind during the review:

• Does the MD&A fully reflect what is being said in the boardroom and at the water cooler?

• Does the MD&A identify the same trends, uncertainties, and contingencies that management and the board have been monitoring? Does it place the same relative importance on them?

• Does the MD&A use the same performance indicators that management uses in analyzing company performance for internal purposes?

• Do the accounting principles underlying the financial statements reflect the policies that the audit committee has determined to be appropriate?

A periodic report that only recites the percentage changes in line items of the financial statements misses the mark -- the investing public can make those calculations. What the report should provide is analysis -- an understanding of what the changes mean to the company.

If the periodic report “gets it right,” it will reflect the financial condition, the results of operations, and the significant trends and uncertainties facing the company as the insiders see them. That’s a story worth reading.

Doug Raymond is a partner of the law firm Drinker Biddle & Reath LLP and heads its Corporate and Securities Group. He is the “Legal Brief” columnist for Directors & Boards. The firm’s Web site is http://www.drinkerbiddle.com, and the author can be contacted at douglas.raymond@dbr.com.