Disclosure Strategy: A Case of Ethics in Financial Reporting

The competition is named in memory of Carl Menconi, who held leadership positions in IMA for many years and served as chair of the IMA Committee on Ethics. The objective of the competition is to develop and distribute business ethics cases with specific application to management accounting and finance issues and that use the IMA Statement of Ethical Professional Practice as a reference or guidance tool.

The winning case and teaching notes are available for use in a classroom or business setting. IMA academic members can access and download the teaching notes from the Academic Teaching Notes library via the IMA Educational Case Journal section of IMA’s website.

Nicholas Alexander stared dejectedly at his computer screen as it displayed the third quarter’s financial statements for Logistics Exchange Market (LEXM) Corporation. The immediate task at hand was preparing for LEXM’s earnings announcement and the conference call that followed, a process that he had become quite accustomed to. Still, he had a sinking feeling that the public reporting of this quarter’s results would be far more challenging than any thus far.

As CFO and one of the first employees hired in the early stages of LEXM’s existence, Nick felt a deep responsibility for its continued success and, in particular, its reputation as a trustworthy and transparent discloser of financial information. Although this was only its fifth year in operation, the explosive growth in demand for its services and coincident increase in revenue allowed LEXM to complete one of the “hottest” initial public offerings (IPOs) for a company its size in recent memory. The $250 million raised provided financial flexibility and the potential to exploit opportunities for additional growth through internal initiatives and potential acquisitions.

Unlike most companies that limit stock-based compensation to corporate executives, the founders of LEXM sought to hire individuals who were willing to accept lower salaries in exchange for incentive compensation in the form of generous grants of stock options. This philosophy of linking corporate and individual success had attracted extremely capable and highly motivated employees who tended to have a great deal of confidence in their abilities.

Now with the 180-day lockup period (during which employees and other company insiders are prohibited from selling stock) about to expire, there was more pressure than ever to report strong results for the three-month period that had just ended on September 30. For the moment, the chance for hundreds of LEXM employees at all levels (Nick included) to take advantage of this opportunity to sell their stock and enjoy a more secure financial future hung in the balance.

As he tried to focus on writing, Nick couldn’t help but recall his heated discussion earlier that day with Trey Prescott, LEXM’s charismatic but mercurial CEO. Although they had a mostly cordial professional relationship, there were times when the two executives differed vehemently about their opinions on financial reporting strategy. The latest disagreement centered on the extent of disclosure that would be made at the upcoming earnings announcement date.

COMPANY BACKGROUND

LEXM was founded five years ago by Prescott and a small cadre of software engineers. Their lofty goal was to launch a business-to-business platform that would revolutionize the procurement of logistics services. Driven to capitalize on its unique niche strategy, the company was able to operationalize its business plan in a relatively short period of time and was soon open for business.

Since its founding, the company has successfully demonstrated its ability to harness the power and convenience of the internet, employing its patented technology to act as a seamless intermediary between providers and corporate consumers of a wide variety of logistics services. Revenue grew exponentially, attracting attention from industry publications and then, ultimately, the financial media.

Nick was the 10th employee hired and has been the only CFO the company has ever had. To Nick, the past five years have been a whirlwind—the fast pace of a start-up company has been demanding yet exciting, and his contribution to creating the financial infrastructure is unmistakable.

Nick quickly addressed LEXM’s initial cash flow challenges, taking the leadership role on raising capital, including three rounds of equity financing prior to the IPO. As the company’s finance chief, he received significant favorable public recognition as LEXM surpassed its operational expectations and successfully completed its IPO. This brought Nick considerable pride and a sense of satisfaction unmatched in his career to date.

CASH FLOW CHALLENGES

Nick felt the full weight of his responsibilities as CFO as he considered his current situation. On the positive side, LEXM had met analysts’ aggressive expectations for total revenue, revenue growth, net income, and earnings per share during the third quarter. On the negative side, analysts covering LEXM had exerted pressure on the company to provide a forecast of cash flows from operations, beginning with the third quarter. In addition, they requested that LEXM include a statement of cash flows with the company’s earnings release, arguing that it would enhance disclosure and present investors with a more comprehensive view of company performance.

Unfortunately, the third-quarter statement of cash flows prepared by Nick’s financial reporting team showed cash flows from operations that were substantially below the projections provided by the company. This was primarily due to a sharp increase in accounts receivable, offset somewhat by a slower increase in accounts payable.

The increase in accounts receivable was caused by growth in revenue and the granting of 60-day payment terms for customers, which was necessary to compete effectively in the industry. Also contributing to the cash flow shortfall was the promise to pay suppliers within 10 days to entice them to provide top-quality inventory to LEXM. As the business continued to grow, this unfavorable cash flow dynamic would be exacerbated and would require additional financing.

Nick knew that a divergence between net income and cash flows from operations is often a cause for concern when assessing the quality of earnings being reported. Through his command of financial reporting, he knew that a company’s management often chooses accounting methods and estimates to make it easier to achieve performance targets, for example, exceeding prior year’s earnings, meeting or beating analysts’ earnings targets, qualifying for bonus compensation, and avoiding debt covenant violations.

Nick was aware that LEXM would have to answer analysts’ questions regarding the quality of its third-quarter earnings. He believed operating cash flow performance would likely be a focal point of LEXM’s earnings release, particularly since it was the first time the company would report this metric. Nick was confident in his ability to articulate the reasons that cash flows from operations lagged net income, but that wasn’t the entire cause of his consternation.

GROWING TENSION

Nick had met with Prescott earlier to review the financial statements and discuss the strategy for reporting LEXM’s third-quarter operating results. He led the meeting, covering performance highlights as well as the challenge to provide, for the first time, the statement of cash flows as a component of the company’s earnings announcement. Prescott, demonstrating his accounting acumen, quickly focused his attention on the significant difference between net income and cash flows from operations and the negative variance of actual cash flows to forecast.

Anticipating Prescott’s concern, Nick presented a succinct analysis explaining the variance that could accompany the earnings release or otherwise be made available to investors and analysts.

Prescott listened, then shook his head slowly. He curtly reminded Nick of the particular significance of this third quarter and the consequences of not meeting expectations. Prescott continued, noting all the employees and investors who were depending on a strong quarterly performance as the lockup on their shares and options would soon expire, allowing them to realize the financial reward they had worked so hard to attain.

Nick was, of course, acutely aware of the situation as his opportunity for significant economic gain was also at risk. He told Prescott that, in his opinion, being up front and explaining the cash flow variance would show LEXM’s willingness to be forthcoming in its financial reporting. It was a unique opportunity to utilize the statement of cash flows—in particular, its reconciliation of net income to cash flows from operations—and emphasize its usefulness as an enhancement to LEXM’s quarterly earnings information. Prescott considered Nick’s recommendation briefly, then angrily left the meeting without offering any comment, saying only that they would reconvene in a few hours.

A BRAZEN PROPOSAL

Two hours later, Prescott walked into Nick’s office smiling. He sat in the chair opposite Nick’s desk and announced that he had come up with a plan that would resolve the financial reporting issue. Prescott’s plan was straightforward: LEXM wouldn’t include a statement of cash flows with its earnings announcement and would simply continue to provide the same package of disclosure as during previous quarters. The statement of cash flows would be disclosed subsequent to the earnings announcement date as a component of the company’s mandatory U.S. Securities & Exchange Commission (SEC) filing. Any questions concerning cash flow would be deferred until the SEC filing date, with the explanation that the statement of cash flows wasn’t finalized as of the earnings announcement date.

Prescott told Nick to remove the statement of cash flows and any reference to cash flows from the earnings press release. He stressed that LEXM must control the narrative and interpretation of the company’s third-quarter financial performance by focusing on the positive revenue and earnings data.

Although initially uneasy about Prescott’s strategy, Nick decided to consider it objectively and prepare a measured response. He knew that corporate earnings announcements and analyst conference calls are strictly voluntary disclosures with no SEC requirement regarding the timing, content, or audit of the information included. Disclosure quality varies substantially among companies as they craft their preferred communication, highlighting more favorable performance metrics and selectively including or omitting meaningful financial information.

Prescott’s plan was based on the latter, the selective omission of the statement of cash flows as a component of the earnings release, despite the fact that this information was available. It also relied upon analysts and investors being narrowly focused on LEXM meeting expectations for earnings and top-line revenue growth.

DISCLOSURE SCRUTINY

Research has demonstrated that the responses to corporate earnings announcements have been shown to be significantly greater than that of the subsequent, yet more comprehensive, SEC filing (see Eli Amir and Joshua Livnat, “The Economic Consequences of (Not) Issuing Preliminary Earnings Announcement,” working paper, New York University, October 2005). Escalating growth in information channels and the velocity with which financial results are now circulated have likely intensified the market response to new information.

Nick was keenly aware of the latest research and trends. Prescott’s suggested use of selective disclosure would allow LEXM to effectively delay the release of its cash flow information because it didn’t completely support the company’s favored account of its performance. By the time the SEC filing is finally made, it would be well after the market’s most consequential reaction to the earnings announcement and too late for investors who prefer to make timely portfolio decisions using the most complete information available.

From an accounting perspective, this made sense. The three primary financial statements—income statement, balance sheet, and statement of cash flows—are related and measure different aspects of the same transactions affecting a company. Cash flows from operations was designed to reflect the cash effects of income-determining items, therefore serving as an effective cash-based comparative measure to earnings. The symmetry of accrual-based earnings and cash-based cash flows from operations provides a useful and comprehensive means with which to evaluate financial performance. Omitting the statement of cash flows would certainly impair the ability of users to evaluate the quality of LEXM’s earnings.

Disclosure decisions of this magnitude aren’t made easily. Theoretically, companies will voluntarily disclose information in their earnings announcements if they believe it will facilitate positive investor valuation. Conversely, they will withhold disclosure if they believe it will have the opposite effect, as in the selective exclusion of the statement of cash flows in Prescott’s disclosure plan.

WALKING A FINE LINE

Nick began to formulate his response to the CEO’s proposal. Because the SEC didn’t require that a statement of cash flows be included with an earnings release, LEXM certainly had the discretion not to do so. And since no one restricted by the lockup agreement could sell their shares until after the third-quarter SEC filing, there could be no instances of trading on inside information.

Nick surmised that the larger risk wasn’t running afoul of SEC rules, but rather a reputational risk. At the insistence of the equity analysts who cover LEXM’s stock, the company had provided a forecast of cash flows from operations. The analysts would have a reasonable expectation that the company would disclose the actual amount of cash flows from operations with the third-quarter earnings announcement. Providing a statement of cash flows as a component of the earnings release would at least satisfy the demand for information, regardless of performance.

Conversely, Nick believed that selectively withholding disclosure of the statement of cash flows would, at a minimum, raise questions as to why. He was doubtful that the company could appease analysts by deferring any cash flow discussion until the quarterly SEC filing. Under any circumstances, omission of a primary financial statement may prompt ethical concerns. This concern would likely be compounded when the statement of cash flows is finally disclosed with the SEC filing. Wouldn’t there be suspicion that the company purposely excluded the statement of cash flows because it revealed negative cash flow performance and an unfavorable variance to the company’s forecast?

HIGH STAKES

Nick had worked very hard to establish the financial reporting reputation of LEXM. The IPO alone required many all-nighters to say nothing of working long days and weekends. Suddenly, LEXM was a public company with periodic reporting demands, essential financing needs, and daily contact with various stakeholders. While the CEO and board of directors had the ultimate responsibility for the corporation, Nick was the primary person for all matters related to accounting and finance. If Prescott’s reporting strategy failed, Nick would very likely be the one in the spotlight.

Of course, no analysis of this situation would be complete without consideration of the positive economic impact on hundreds of LEXM employees, executives, and loyal early investors who stood to gain financially from a smooth earnings season. If LEXM’s stock price remained close to its current level after the earnings announcement and subsequent SEC filing, the wealth implications for those in a position to sell stock would be potentially life changing. Nick knew that many of his colleagues and friends were depending on him to help them realize their dreams. If all went well, the years of hard work and commitment would finally be rewarded, and Nick himself would become a millionaire.

It seemed to Nick that the probable path of least resistance would be to accept Prescott’s plan. It was certainly feasible that LEXM’s successful revenue and earnings performance could be the focus of the company’s disclosure, especially if the earnings announcement were tailored to deliver that specific message. It was also reasonable that the company required additional time to construct its statement of cash flows, especially since it had never previously provided this information.

Concurrent with the SEC filing, LEXM could post Nick’s analysis of the cash flow discrepancy on the investors’ section of its website so that analysts, investors, and the financial press would have a tool for easily understanding its causes. LEXM would be in compliance with all SEC requirements, and the additional disclosure may just pass under the radar. If the stock price held and selling could occur after the lockup expired—well, that would be the best outcome he could hope for.

ETHICAL CONFLICT

While going along with Prescott’s plan may be the easiest thing for Nick to do, his misgivings about the selective disclosure strategy persisted. Acknowledging that there was nothing illegal about selective disclosure (in this case, the omission of the statement of cash flows from LEXM’s earnings release), he nevertheless felt uncomfortable about purposefully withholding information that was readily available. This was information that LEXM had promised to provide and that Nick believed was relevant to the many users of the company’s financial statements.

He didn’t want to jeopardize the relationships and trust he had built with analysts and investors. Nick also had his own future career and professional reputation to be concerned with.

As Nick searched for tenable solutions to LEXM’s financial reporting challenge, he recognized that this situation had presented him with a serious ethical conflict. For guidance, he initially turned to LEXM’s Code of Ethics but found its provisions too general and imprecise to be of much assistance. Nick knew that it wasn’t unusual for such documents to be written with the intention of allowing broad interpretation.

As he sought out something more useful, Nick recalled his most recent experience with ethics training, a continuing professional education (CPE) course offered by IMA^® (Institute of Management Accountants). As a CMA^®(Certified Management Accountant), he was required to complete 30 hours of CPE annually, including at least two hours of ethics-related training.

His latest ethics course still fresh in his mind, Nick remembered that all IMA members were required to abide by the IMA Statement of Ethical Professional Practice. He accessed the Ethics Center on IMA’s website and read through the IMA Statement (see below). He began with the overarching ethical principles of honesty, fairness, objectivity, and responsibility, before moving on to review the ethical standards of competence, confidentiality, integrity, and credibility. Each standard has three to four underlying tenets that provide further description and support. Nick realized that the IMA Statement was sufficiently comprehensive to utilize as a framework with which to analyze, and hopefully resolve, his ethical dilemma.

IMA Statement of Ethical Professional Practice

Members of IMA shall behave ethically. A commitment to ethical professional practice includes overarching principles that express our values and standards that guide member conduct.

PRINCIPLES

IMA’s overarching ethical principles include: honesty, fairness, objectivity, and responsibility. Members shall act in accordance with these principles and shall encourage others within their organization to adhere to them.

STANDARDS

IMA members have a responsibility to comply with and uphold the standards of competence, confidentiality, integrity, and credibility. Failure to comply may result in disciplinary action.

I. Competence

1. Maintain an appropriate level of professional leadership and expertise by enhancing knowledge and skills.
2. Perform professional duties in accordance with relevant laws, regulations, and technical standards.
3. Provide decision support information and recommendations that are accurate, clear, concise, and timely. Recognize and help manage risk.

II. Confidentiality

1. Keep information confidential except when disclosure is authorized or legally required.
2. Inform all relevant parties regarding appropriate use of confidential information. Monitor to ensure compliance.
3. Refrain from using confidential information for unethical or illegal advantage.

III. Integrity

1. Mitigate actual conflicts of interest. Regularly communicate with business associates to avoid apparent conflicts of interest. Advise all parties of any potential conflicts of interest.
2. Refrain from engaging in any conduct that would prejudice carrying out duties ethically.
3. Abstain from engaging in or supporting any activity that might discredit the profession.
4. Contribute to a positive ethical culture and place integrity of the profession above personal interests.

IV. Credibility

1. Communicate information fairly and objectively.
2. Provide all relevant information that could be reasonably be expected to influence an intended user’s understanding of the reports, analyses, or recommendations.
3. Report any delays or deficiencies in information, timeliness, processing, or internal controls in conformance with organization policy and/or applicable law.
4. Communicate professional limitations or other constraints that would preclude responsible judgment or successful performance of an activity.

Resolving Ethical Issues

In applying the Standards of Ethical Professional Practice, the member may encounter unethical issues or behavior. In these situations, the member should not ignore them, but rather should actively seek resolution of the issue. In determining which steps to follow, the member should consider all risks involved and whether protections exist against retaliation.

When faced with unethical issues, the member should follow the established policies of his or her organization, including the use of an anonymous reporting system if available.

If the organization does not have established policies, the member should consider the following courses of action:

• The resolution process could include a discussion with the member’s immediate supervisor. If the supervisor appears to be involved, the issue could be presented to the next level of management.
• IMA offers an anonymous helpline that the member may call to request how key elements of the IMA Statement of Ethical Professional Practice could be applied to the ethical issue.
• The member should consider consulting his or her own attorney to learn of any legal obligations, rights, and risks concerning the issue.

If resolution efforts are not successful, the member may wish to consider disassociating from the organization.