How ‘Tone At The Top’ Still Dogs Companies

Whether the fault lies with poor attitude or poor execution, four years after Sarbanes-Oxley was passed to galvanize the spirit of corporate governance, some companies are still painfully out of tune on that point.

In a Compliance Week analysis of 2005 material weakness disclosures, 20 of the 400 companies surveyed confessed to internal control problems numerous and pervasive enough to indicate a larger problem: the dreaded “tone at the top.”

Only a tiny fraction of those 20 companies were so explicit in describing the problem behind the problems. Stone Energy Corp., a $630 million energy concern, reported bluntly: “We lacked adequate internal guidance or training on the (Securities and Exchange Commission’s) definition of proved reserves. There is also evidence that there was an optimistic and aggressive ‘tone from the top’ with respect to estimating proved reserves.”

Paradoxically, tone at the top has become an important job requirement for senior executives at public companies in the post-Enron era. But at the same time, there are no bright lines in the regulatory rules or accounting standards that define it.

John Morrow, vice president at the American Institute of Certified Public Accountants, says the market definitely knows what tone at the top is, even if companies don’t rush to declare themselves as having a problem with it.

Morrow

“Tone at the top is one of those ones where it’s hard to define it, but you know it when you see it,” Morrow says. “It means anyone who is a role model for people is doing the right thing, basically.”

The Committee of Sponsoring Organizations, authors of the internal control framework widely used by Corporate America to document and test controls over financial reporting, says the control environment is key to setting the tone of the organization because it influences the “control consciousness of its people.”

With only one company in an analysis of 400 specifically defining its problems as rooted in tone at the top, does that mean executives have taken to heart the lessons of massive corporate failures and subsequent harsh penalties? Are they shoring up controls in a spirit of achieving a strategic business improvement and setting a good attitudinal example for employees?

Turner

Not necessarily, says Jonathan Turner, managing director of the investigation consulting firm Wilson & Turner and a certified fraud examiner. Management doesn’t always make a connection between the control environment and the tone at the top, he claims. “Corporations regard controls as a necessary evil, not as having any strategic business purpose.”

Morrow is a little more optimistic. “I would hope they see it as a business imperative and not just as a compliance imperative,” he says.

But John Gill, research director at the Association of Certified Fraud Examiners, minces no words: “Senior management doesn’t have a connection between internal controls and tone at the top necessarily. Probably most companies are more concerned about just meeting the compliance requirements,” he says.

Companies know they need to have a control-conscious environment and an ethics policy, and that they have to communicate it to employees, Gill says, but he believes they still haven’t baked that awareness deep into the day-to-day conduct of business.

He cites the recent turmoil at Hewlett-Packard as a high-profile example of a company that had all the right elements in place, but didn’t maintain good behavior at the top echelon of management. HP Chairwoman Patricia Dunn announced her resignation just last week after the market learned she oversaw a probe of boardroom leaks where investigators obtained confidential phone records under false pretenses—a move that could result in criminal charges.

“You can’t just send policies out to employees and expect them to abide by them,” Gill says. “You have to act that way as well, and employees have to see that in you. You have to walk the walk as well as talk the talk.”

Turner credits HP for at least taking action, albeit ham-handedly, when it saw its own board members leaking confidential information to the press; events could have been worse had Dunn and other managers simply done nothing.

“They took what they thought was an appropriate response to try to correct the leak, and the people working on it either bent or broke the rules,” he says. “It’s not only about how you attack and resolve issues, but also if you do something wrong along the way. A lot of companies are too paralyzed by fear to do anything. That tone at the top is devastating.”

IN THEIR WORDS

Below excerpts of internal control disclosures about “tone at the top” weaknesses.

Stone Energy Corp.:

“We lacked adequate internal guidance or training on the SEC definition of proved reserves; there is also evidence that there was an optimistic and aggressive “tone from the top” with respect to estimating proved reserves.”

Shurgard Storage Centers:

“We did not maintain an effective control environment. We lacked adequately documented financial accounting and reporting policies and procedures related to the timely preparation and review of our interim and annual consolidated financial statements and supporting schedules. We did not maintain a sufficient complement of personnel with an appropriate level of accounting knowledge, experience and training in the selection and application of U.S. GAAP commensurate with our financial reporting requirements. We did not maintain adequate controls over the preparation of our interim and annual consolidated financial statements, and, our period-end financial accounting and reporting process lacked timely oversight and monitoring by the appropriate personnel necessitated by our decentralized organizational structure.”

Asyst Technologies:

“The financial reporting organizational structure was not adequate to support the size, complexity or activities of the company. In addition, certain key finance positions were staffed with individuals who did not possess the appropriate skills, training or experience to meet the objectives of their job descriptions. This control deficiency indicated that we did not maintain an effective control environment… We did not maintain effective controls over the preparation of our interim and annual consolidated financial statements.”

Source

Corporate Filings

Turner says companies typically identify a tone problem only when it’s called to the company’s attention from the outside, such as by a regulatory body, an oversight board, an audit report, or a legal judgment. The most common approach to correct it, he says, is a change in personnel.

“I don’t think I’ve ever seen it corrected without a personnel change,” he says. “You’d like to think it’s theoretically possible, but that means you have to fix the person. When people are doing an analysis on themselves, it’s difficult to be honest about what you’re good at and what you’re bad at, especially when you go up the chain of command and people have been successful at a lot of things. When that’s the case, it’s hard to see the need to change any behavior.”

Stone Energy didn’t sweep out any executives or board members following its 2005 filing (nor did it respond to Compliance Week’s request for comment), but the company announced in June that it is merging with another energy concern, Energy Partners. That was the path as well for Shurgard Storage Centers, which disclosed extensive problems with internal controls. It was acquired and delisted earlier this year.

Natural Health Trends, a $195 million direct-sales consumer products company, made broad concessions to an ineffective control environment, although it didn’t go so far as to ascribe the problems to a tone at the top. The company described its situation as: “Our policies regarding review, supervision, and monitoring of our accounting operations throughout the company were not fully designed, in place, or operating effectively. We lacked appropriate review, approval, and supporting documentation.”

In late July, the company announced it had appointed a new president and chief executive officer, Stephanie Hayano, boasting of her “extensive and successful track record managing corporate turnarounds and leading diverse, international management teams.”

Likewise, construction company Chicago Bridge & Iron reported extensive internal control problems and ousted its chief executive, operating, and financial officers earlier this year.

The key to identifying whether a company has a problem with tone at the top, Turner says, is attitude. “Is the attitude to blame everyone else, or to accept it, fix it, and address it?” he said. “Tone doesn’t mean you have no issues. It means when you have an issue, you respond to it.”