Honing Skepticism Remember President Ronald Reagan’s foreign policy mantra, “Trust, but verify”? That idea is at the heart of a collaboration by leading business organizations, including NACD, to prevent fraud by honing the skill of skepticism in the financial reporting chain, which leads right through the boardroom. Editor’s note: This article is based on webinars financial reporting chain, including directors. and related research conducted as part of an Everyone involved in a company’s financial re- ongoing Anti-Fraud Collaboration initiative porting effort can benefit from skepticism. After (antifraudcollaboration.org). As such, it reflects all, they need every possible weapon at hand contributions from Anti-Fraud Collaboration to hack away at the legendary fraud triangle, members. Responsibility for the content of this ar- the three factors—as explained in the Center ticle, however, lies solely with NACD. for Audit Quality’s 2010 report Deterring and Detecting Financial Reporting Fraud: A Platform Must directors be skeptics? for Action—that when combined often lead indi- It’s a challenge worth examining. The term viduals to commit fraud: pressure (or an incen- “skepticism” is often associated with doubt, but tive or motive) to engage in fraud; a perceived it actually describes a search for the truth. The opportunity; and the ability to rationalize fraudu- word comes from the Greek skeptikos, used some lent behavior. A passage from that report reveals 2,300 years ago by disciples of the philosopher the magnifying power that skepticism can have: Pyrrhus. The verb skeptesthai means “to reflect, “Skepticism throughout the financial reporting look, view.” supply chain increases not only the likelihood The earliest self-declared skeptics empha- that fraud will be detected, but also the percep- sized the importance of the senses in confirming tion that fraud will be detected, which reduces reality. Over time, the word’s meaning expanded the risk that fraud will be attempted.” to include the notion of reasonable doubt. The CAQ report notes that management exer- Today, the “skeptic” is perceived as a doubter, cises skepticism by periodically testing assump- someone who may trust but must always verify. tions about financial reporting processes and As such, embracing skepticism carries unique controls, and recommends that boards and audit role-related challenges for each member of the committees take a skeptical approach in their January/February 2013 www.directorship.com 29 Cover Story work. The report also states that for both internal desirable director trait. BRT’s 2012 Principles of and external auditors, skepticism is integral to the Corporate Governance notes that “effective direc- conduct of their professional duties, pointing out tors maintain an attitude of constructive skepti- that those auditors can “provide insight into the cism; they ask incisive, probing questions and company’s ethical culture and the effectiveness of require accurate, honest answers.” its internal controls to assist board and audit com- “If we take a look at the widely reported fail- mittee members in exercising skepticism.” ures that have recently occurred, many times it’s a lack of adequate skepticism that is the common Sharpening Independence denominator. But skepticism is very different from Although no professional standard requires di- playing devil’s advocate, asking uninformed ques- rectors to exercise skepticism, this attitude is tions or being argumentative,” says NACD Presi- “Skepticism clearly implied by the concept of director inde- dent and CEO Kenneth Daly. “It’s about under- pendence, required in the United States under a standing the industry and the business, applying is very number of existing standards set by Congress, the your business acumen to the subject matter, different from Securities and Exchange Commission and the and requiring logical responses to relevant, well- stock exchanges (see related sidebar, “Director formed questions.” playing devil’s Independence Requirements,” opposite page). advocate.…It’s Director independence—as interpreted today A More Effective Audit Committee Chair about applying by leading organizations including the NACD— The audit committee chair plays an important role requires an independent mind-set; this in turn in the exercise of skepticism needed for indepen- your business makes skepticism possible, as the two traits are dence. An effective chair does a lot of pre-work acumen to closely related. with the CFO, the chief internal audit executive NACD has long recognized independence and and the external auditor. As the chair facilitates the subject skepticism as valuable traits for audit committee the meeting, it is important for him or her to know matter and chairs. The 1999 Report of the NACD Blue when to go deep and when it is time to come back requiring logical Ribbon Commission on the Audit Committee: up to the real issues. A Practical Guide linked audit committee ef- “I know from my experience sitting on audit responses fectiveness to the “independence, competence, committees for multinational companies that to relevant, dedication and leadership skills of the audit there is a lot of complex information behind each well-formed committee chair.” The commission, led by the ‘number’ for a financial statement,” says Hooper. late A. A. Sommer Jr., a former commissioner of An effective chair solicits input from all audit questions.” the SEC, noted that the chair “will ideally be committee members, not just the designated —Kenneth Daly a highly respected, highly experienced director financial expert. Indeed, sometimes the best who demonstrably possesses the attributes of questions come from people with nonfinancial intellectual curiosity, a skeptical eye and ear, te- backgrounds. nacity and courage.” Audit committee oversight and support of in- A subsequent commission—co-chaired in 2010 ternal audit are essential for assuring an indepen- by Dennis Beresford, former chair of the Financial dent, objective and skeptical internal audit func- Accounting Standards Board; and Michele Hooper, tion. Audit committees have primary responsibility audit chair at PPG Industries, director of United- for hiring the external auditor, as mandated under Health Group and NACD, and co-chair of the Anti- the Sarbanes-Oxley Act of 2002. Clearly, audit Fraud Collaboration, an initiative supported by the committees should assess skepticism when se- CAQ, Financial Executives International, the Insti- lecting auditors or evaluating their performance. tute of Internal Auditors and NACD—reinforced But this is not the only role they play. these same themes. The NACD Blue Ribbon Commission report Business Roundtable also cites skepticism as a warns, “Effective audit committees are not and 30 NACD Directorship January/February 2013 cannot be auditors.” Rather, audit committee independent data points, this may point very members should focus on reviewing financial early to…a potential problem.” risks and overseeing risk management. “While Directors can benefit from the advice offered they should exercise constructive skepticism as in Enhancing Board Oversight: Avoiding Judg- they question management and auditors about ment Traps and Biases, a March 2012 publica- the quality of management’s financial reporting tion produced by the Committee of Sponsoring and the quality of controls, they must rely for Organizations. Authors Steven M. Glover and the most part on the financial and reporting Douglas F. Prawitt note that “…in a world of judgments of the full-time managers and profes- high-stake decisions, deadlines, and limited ca- sionals, and the advice and reports of the audi- pacity, the judgments of even highly educated, tors,” the report states. capable people are vulnerable to common, sys- “Deviance from revenue recognition policy tematic traps and predictable biases.” “Deviance is frequently the most common example of fi- Using an example from the audit realm, nancial statement fraud in a company,” explains Glover and Prawitt note that in collecting and from revenue Martin M. Coyne II, lead director and audit assessing audit evidence, auditors often are con- recognition committee member at Akamai Technologies. fronted with issues that need to be addressed. “An audit committee can start by looking at a Therefore, they need to identify the problem policy is policy, then move to what adjustments have been (for example, sales revenue is inconsistent with frequently the suggested by the external auditor, then move to customer counts) and then begin to consider al- most common items like the number and size of credits issued ternatives (why might sales revenue be higher in and the trends in bad debt reserves and revenue this period when the number of customers has example reserves. If you connect the dots from all of these decreased?). of financial statement fraud Director Independence Requirements in a company.” The Sarbanes-Oxley Act of 2002 requires inde- governance committees must be independent— —Martin M. pendence for public company audit committee thus extending beyond SOX and Dodd-Frank members, and the Dodd-Frank Wall Street Reform when it comes to the nominating/governance Coyne II and Consumer Protection Act of 2010 requires committee. independence for compensation committee Nasdaq also states that a majority of directors on members. These requirements apply to all public the boards of listed companies must be indepen- companies, regardless of stock exchange, with dent, defining an independent director as one who