How much does any CEO know about his company’s finances? How much should he know?
Those are the central questions in the trials of several chief executives accused of masterminding their companies’ massive accounting scandals. These CEOs claim they knew nothing of the financial machinations that rocked their companies. In each case, they insist, a manipulative and conniving CFO acted alone.
But the amiable-dunce defense has failed spectacularly at least once. This past March, former WorldCom CEO Bernard J. Ebbers was found guilty of conspiracy, false regulatory filings, and securities fraud in connection with the 2002 demise of the telecom giant—convicted despite his insistence that former CFO Scott Sullivan unilaterally cooked the books. (Sullivan, the prosecution’s star witness, admitted to the cooking, but testified that his former boss held the frying pan, a scenario the jury found more plausible than Ebbers’s version.) Similarly, Richard Scrushy, former CEO of HealthSouth, maintains in his ongoing trial that conspiring executives, including five former CFOs, committed the $2.7 billion fraud there. And Kenneth Lay, former Enron chairman and CEO, is widely expected to employ the ignorance defense when his first case gets under way, perhaps as early as next month.
So what gives? All these top executives insist they didn’t possess the knowledge necessary to execute the frauds in question.
But is it really possible for a CEO to be clueless about the financial condition of his own company? To find out, CFO magazine asked CFOs (who presumably know more about their bosses’ financial acumen than anyone else) whether it would be possible for their CEOs to legitimately claim ignorance.
The answer, to our surprise, is maybe. A full 31 percent of public-company CFOs said that before the passage of the Sarbanes-Oxley Act in 2002, their CEOs might have been ignorant of major financial fraud in their companies. Only 49 percent said that would have been impossible. Twenty percent were unsure.
The fact that so many public-company CEOs could plead ignorance of their companies’ finances makes a powerful case for the new government safeguards. Says Michael Short, CFO of Universal Orlando: “Sarbox did a lot to debunk the ‘Sergeant Schultz defense.'” (Schultz, as some may recall, was a Nazi guard in the 1960s TV show “Hogan’s Heroes,” whose stock response to every question was, “I know NUSS-ing.”) “Companies now have so many people telling the CEO what’s going on,” Short adds, “that the chances of him (or her) saying ‘I didn’t know’ with any credibility are greatly diminished.”
Indeed, new penalties for false filings, certification requirements, and internal-control assessments offer powerful incentives for CEOs to pay attention to their companies’ financials. According to our survey, they do. CFOs report that today, in 95 percent of public companies, CEOs are either moderately or deeply involved in significant corporate-finance decisions. Fully 80 percent of public-company CEOs understand financial issues very well or extremely well, and another 18 percent understand them moderately well. No longer, for example, can a CEO claim just a rudimentary knowledge of cash flow. “Five years ago,” says Bob Davis, CFO of Computer Associates (CA) and former chief accounting officer at Dell Inc., “a lot of CEOs would have been primarily focused on income statements,” but not the cash-flow statement. “I’m certain that won’t be the case in the future. As we move more toward fair-value accounting, the cash-flow statement has become more and more important.”
No surprise, then, that 71 percent of CFOs surveyed believe that in the wake of Sarbox, it would be impossible for their CEOs to remain ignorant of major financial fraud. Only 14 percent said their CEOs could still be unaware today, and another 14 percent were unsure.
Striking a Balance
Of course, a CEO’s level of financial literacy varies depending on previous experience, type of company, and concern about Sarbox, among other factors. For instance, Fred Poses, chairman and CEO of American Standard Cos., started his professional life as a financial analyst—but that doesn’t mean he considers himself an accounting expert. “I’m not responsible for making sure the debits and credits fit together,” he says. He views his role as ensuring proper controls and authorizing the necessary resources to maintain those controls. “At the end of the day,” he adds, “the CEO is not the CFO, nor should he want to be.”
Then there are CEOs like Garry Betty of EarthLink Inc., who calls himself “obsessive” about accounting details, and actually reads Financial Accounting Standards Board pronouncements. Betty admits that his eyes glaze over on some of the nuances. But, he says, “I read all the new regs that come out, and if I don’t understand them, I talk to my CFO [Kevin Dotts] until I understand the concepts.”
Betty’s interest in accounting stems from his first job while in college at a small manufacturing company, where he oversaw all the accounting, including accounts payable and receivable. At EarthLink, Betty stays “positively involved with the details,” says Dotts, adding that he wants his boss “to be as involved as he can without becoming distracted from the things he needs to get done.” In Betty’s case, that means taking an active role in closing activities and serving on the steering committee for Sarbox efforts.
For his part, Dotts says he doesn’t feel second-guessed by the CEO’s financial acumen. “I certainly don’t feel there is infringement,” he says. “It’s a cohesive relationship.” Still, there is a delicate balance that CEOs must strike between being overly hands-off and overly hands-on. And post-Sarbox, that means knowing as much as possible about finance, but allowing the CFO to do his or her job.
To strike that balance, Mike Jackson, chairman and CEO of AutoNation since 1999, says he has gained a full understanding of the financial principles and metrics that most affect his company. He realized the benefit of such knowledge when he was launching a business in his late 20s. “We were in a meeting, and I couldn’t follow some of the detailed financial and balance-sheet discussion,” recalls Jackson. “I [couldn’t figure out] what should be done, because I couldn’t understand the issues.” Realizing that his ignorance put him at a disadvantage, Jackson went back to school to study accounting and finance.
Jackson’s CFO, Craig Monaghan, who joined AutoNation in 2000, thinks his CEO “has hit the balance perfectly. He is involved with strategic issues, he has a solid grasp of financial statements, but he does not become involved with the minutiae. He’ll go through the financial issues in whatever detail needed, but he doesn’t try to dictate accounting policy.” In practice, says Monaghan, that means Jackson may be deeply involved in capital-expenditure and share-repurchase decisions, but not in how to account for a sale-leaseback for the company’s headquarters.
What’s different at Cypress, California-based managed-care provider Pacificare Health Systems, says CFO Gregory Scott, is that CEO Howard G. Phanstiel was formerly CFO, so “by nature he tends to stay closely attuned to the financial underpinnings of the company.” For example, the level of review that Phanstiel gives to monthly financial and operating results is much more in-depth than that of the average CEO. Still, no matter what a CEO’s background, says Scott, he must develop “a clear understanding of the financial process” in order to have confidence in its execution. No CEO is going to know the details of every individual transaction in a large organization, he explains, “but he has to know that no matter how far-flung the division, the process is operating.”
Ironically, as more CEOs respond to the pressure to learn about finance, some have taken the mandate too far. “The pendulum has swung back,” says CA’s Davis. Just a few years ago, CFOs had “to work hard to get the CEO to focus on certain things. Today, a CFO has to worry “if he has a CEO who is spending a disproportionate amount of time on finance when he should be thinking about strategy.”
Indeed, CFOs who find themselves in in-depth discussions with their CEOs about lease accounting or international convergence might want to start managing up, says Michael Useem, director of the Center for Leadership at the University of Pennsylvania’s Wharton School. Finance chiefs, he says, need to “make explicit where the line is between what the CEO should know and become engaged in and what the CFO doesn’t need CEO input on.”
Useem points out that boards of directors are now facing the same question, and many have started writing “delegation of authority” documents that spell out which matters they want to review and which they don’t. Such an agreement, if applied to the CEO/CFO relationship, says Useem, might conclude that anything that is strategic—as well as anything that raises ethical or legal questions—should come before the CEO. Anything else—routine accounting treatments, banking decisions, assumptions about the rate of return when calculating pension returns—would remain the CFO’s sole purview. Some matters, he says, will concern both.
Some CFOs balk at this notion. “It’s the CEO’s prerogative to get deeply involved in any aspect of the business,” says AutoNation’s Monaghan. “I don’t have an issue with that.” But he admits to disagreeing with CEOs about accounting in previous jobs, and arguing, “Look, this is my job. This is what I get paid to do.”
Monaghan recalls drawing this line in the sand with the CEO at his last company, iVillage Inc. Just before the company’s initial public offering in 1999, a former CFO made allegations that sparked a Securities and Exchange Commission investigation and threatened the IPO. A summit meeting was scheduled with Monaghan, the company’s audit team, and the SEC to give the company an opportunity to demonstrate why the IPO should proceed. Shortly before the meeting, iVillage’s co-founder and then-CEO, Candice Carpenter, approached Monaghan and said, “Maybe I should go with you and talk to the SEC,” recalls the finance chief.
Up until then, says Monaghan, “I’d been managing the whole problem, the investigation, the IPO. My response was, ‘This is my responsibility; let me manage it. If we’re unsuccessful, I’ll accept full responsibility.'” In the end, Monaghan, accompanied by the company’s auditors and lawyers, resolved the questions to the satisfaction of the SEC. “She trusted me,” he says, “even though it must have been very difficult for her to let go of the reins on something so important.”
A Leadership Moment
In the areas in which CEOs still lack critical financial understanding, says Useem, it is vital for CFOs to bring them up to speed. “It’s really a moment for CFO leadership,” he says. “How do you get someone to do something they’re not inclined to do? You have to view that relationship as one in which you’re going to help [the CEO] do what is right even if he’s not inclined at first blush to do so.”
In practice, the financial literacy of the CEO matters less than his ethical literacy. Indeed, pressure to commit fraud often comes from the top, as the CFOs in many of the high-profile cases have testified. “And the minute [any] CEO [says] to be creative, that executive is in trouble, whether he knows the details or not. Whether he got involved in how the books were cooked or not, if he intimated that the CFO and finance staff should look for ways to fill the gaps—bam. Guilty.”
Messrs. Ebbers, Scrushy, and Lay had better pay attention.
Kris Frieswick is a senior writer at CFO.
Three Blind Mice?
Richard Scrushy, Kenneth Lay, and Bernard J. Ebbers have all claimed ignorance about the financial condition of their fraud-riddled companies. A federal jury has already found Ebbers guilty of nine counts of securities fraud, conspiracy, and false regulatory filings. Scrushy’s trial for violation of the Sarbanes-Oxley Act was under way at press time. And Lay is expected to face the music on bank-fraud charges as early as June and securities-fraud charges next January.
Regardless of the outcomes, these chief executives should not expect much sympathy from their peers. Whether or not their claims of ignorance are true, CEOs and CFOs polled on the subject have some choice words for the three. “Saying you didn’t know what was going on in your own company is ridiculous,” says Mike Jackson, chairman and CEO of AutoNation. “You’re either lying, or you shouldn’t have the responsibility to begin with. It’s just utterly ridiculous.”
Jackson believes that Lay’s guilt or innocence has nothing to do with whether or not he understood Enron’s financial condition. “Lay and the board granted the CFO [Andrew Fastow] an exemption from conflict-of-interest rules; then no one tried to make sure the conflict was handled right. They had an extraordinary responsibility to put in a process to manage the exemption. That has nothing to do with finance or accounting.”
As such, these executives say that Lay, Scrushy, and Ebbers failed in their most basic duty to their shareholders—oversight of the corporation. “You can’t be in business without understanding the factors that drive the cost,” says Garry Betty, CEO of EarthLink Inc. “You have to look at your cash-flow statement. If any of these CEOs simply focused on [that], he would have seen something amiss. At WorldCom, it was $11 billion [worth] that was amiss. How could he not see it?”
Bob Davis, the new CFO of Computer Associates, which recently suffered its own accounting scandal, says, “It is never a viable defense” for a CEO to claim ignorance of the workings of his own organization. The job of a CEO is to stay intimately involved with his company, a role that far too many CEOs are abandoning in order to become global, says Gregory Scott, CFO of Pacificare Health Systems. “Some CEOs start thinking that hanging out in Washington is more important than understanding what is happening with their businesses,” as Lay did when he became involved with President George W. Bush’s special task force on U.S. energy policy. “If you want to be a figurehead, you’d better drop the CEO title and take another. You can’t distance yourself from your own company, turn it over to someone else, and then [take] the ‘I didn’t know’ defense.”
Sadly, it’s hard to find anyone who thinks this is the last we’ve seen of the CEO perp walk. “It’s not the last time we’ll see CEOs or CFOs in the courtroom,” says Michael Short, CFO of Universal Orlando. “Greed is a powerful emotion.” —K.F.