Truth in Financial Reporting: Is Your CEO Lying?
By Jan Alexander

AI, a focus on non-financial data and more may shed light.

Investors who want to know what’s going on at a company beyond the quarterly financial results and standard accounting metrics have a growing wealth of sources to consult. That makes the audit committee’s task of staying on top of financial reporting integrity more challenging than ever.  

Digital analysis is beginning to unearth an explosion of data that companies will need to harness as part of any discussion of performance. And corporate leaders are under increasing scrutiny to use all of the data at their disposal to tell investors and other stakeholders what is happening, beyond just generally accepted accounting principles, or GAAP.

“A core function of the audit committee is to stand in the shoes of investors,” says Cindy Fornelli, the executive director of the Center for Audit Quality (CAQ) in Washington, D.C., an audit standards advocacy organization. “And what we’ve heard from investors is that they want meaningful and relevant disclosures, so the audit committee should not only advocate for this, but should take a leading role in working with company management on how best to provide this information.”

As far as technological advances, audit firms have begun to invest in cognitive technologies that will make it possible for the audit process to provide an increasingly broader range of perspectives on a company’s performance and risk factors. Investment researchers are starting to use AI, big data and predictive analysis to get a sense of what’s going on behind the numbers and where the biggest risks are.

There is a growing industry of analysts who use a number of strategies, including linguistic and psychological judgement, lie detector tools, and the cognitive technologies that enable artificial intelligence to judge whether a company’s senior executives are telling investors and other stakeholders everything they really need to know.  

One example is Able Markets in New York, which is using big data for all-encompassing analysis of publicly-traded companies.

Investors hire the firm to sit in on management calls with analysts and then use software to assess cues in the executives’ speech patterns that indicate how confident they are in their own words, says Irene Aldridge, a managing partner. The firm can also create a multi-dimensional heat map that incorporates the speech pattern analysis with other financial and non-financial data.

Other such analysts on the lower-tech side include Laura Rittenhouse, founder of the 17-year-old research firm Rittenhouse Rankings in New York, who studies shareholder letters to see if the message seems truthful and to-the-point; Business Intelligence Advisers in Boston, which uses CIA lie detector techniques to scrutinize corporate disclosures; and Valens Securities in Cambridge, Mass., which combines its own lie detector technology with analysis based on uniform accounting metrics.

When it comes to financial measurements required in Securities and Exchange Commission (SEC) filings, non-number related information is gaining traction.

Such information could include insights into the character and integrity of the senior managers, which analysts might obtain by compiling data from the news and social media as well as the company’s network of clients and suppliers, and evidence of how sincere the CEO seems to be when he or she says the company is headed for a great year of record growth. That is something analysts can try to gauge using lie detector techniques.

“It’s a difficult balance for the audit committee, because it’s not black and white,” says Elizabeth Saunders, a partner at Clermont Partners in Chicago, a strategic communications firm for the financial services industry. She has been talking with investors about what they want to know, and says the audit committee should be asking questions not only about specific numbers, but also about whether the company is presenting its guidance in a way that reflects the true earning power of the business. 

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Enough companies were supplementing their GAAP-compliant SEC filings with other metrics that in May 2016 the agency issued new guidance on the use of non-GAAP financial measures, aimed at making sure companies disclose what metrics they’re using and then report results consistently, rather than varying the accounting method from quarter to quarter based on which numbers make the company look good. Many companies are now starting to see it as an opportunity to go ahead and make use of meaningful information.  “I think the buy side has made it clear that if it’s a better way to tell your story you should provide non-GAAP guidance as well,” says Saunders.

Clermont Partners conducted a recent survey of active investors titled “More Active Investors Rely on Non-GAAP vs. GAAP Reporting in Analyzing Stocks, ” and found 74% of respondents relied on non-GAAP reporting more than GAAP in evaluating a company’s performance. While the main non-GAAP measures they use are financial — free cash flow, EBITDA, and adjusted net income or adjusted earnings per share — 64% said they view intangible assets as ‘important’ to ‘absolutely critical’ in their evaluation, such as intellectual property, goodwill, brand recognition and a skilled work force.

Audit committees need to have a lot of conversations within the organization this year, says Marc Macaulay, KPMG’s Cognitive Technology Audit Leader, adding that it falls to the audit committee to ask all of business functions about how they’re using advanced technology. Among the most important questions, he adds, “the audit committee needs to be looking at whether the CEO and CFO are articulating a position that’s consistent with the insight that’s being derived from all of the data.” 

Jan Alexander has written about financial markets, management strategy and the global economy for Strategy+Business, Institutional Investor, Forbes, Worth, and Money.


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