Roman L. Weil is appalled by what he doesn’t see on boards. Weil is an accountant on a mission: to expose financial illiteracy on corporate boards and fix it. As a chaired professor of accounting at the University of Chicago’s Graduate School of Business; a consultant to the SEC, the U.S. Treasury, and the Financial Accounting Standards Board; and the chair of an audit committee affiliated with New York Life Insurance (one of its mutual funds groups), Weil has little patience for those who don’t get how serious and widespread the problem is. Without financial literacy, he says—the ability to understand how and why management makes the accounting decisions it does—management can manipulate the books as it sees fit while keeping the board in the dark. Following are edited excerpts from a discussion Weil had with HBR’s Gardiner Morse. What makes you think financial literacy is rare on audit committees? It’s simple. When we test board members’ literacy, they bomb. My colleague Katherine Schipper and I have been giving a multiple-choice quiz to corporate board members for several years. We’ve had more than 800 respondents volunteer to take the quiz, which we give to people attending our directors’ educational programs at the University of Chicago, Stanford, and Wharton. Twenty percent of those attendees are on audit committees. Only about half the directors we’ve asked to take the quiz have agreed to, which says something in itself. We suspect that those who do volunteer have more confidence in their knowledge about accounting than those who opt out [and therefore probably include a disproportionate percentage of audit committee members]. Nonetheless, the respondents’ median number of correct answers is 10 out of 25. We have one question on retained earnings, a subject covered in the first or second chapter of any basic accounting book. Only 23% of our respondents get that one right. (See the exhibit “Test Yourself.”) Test Yourself Roman Weil and Katherine Schipper have developed a 25-question, multiple-choice quiz to test board members’ financial literacy. A sample of the questionnaire appears below. The full text is available online at http://gsbwww.uchicago.edu/survey/financialliteracy.html. 1. Retained earnings on the balance sheet is an account usually referring to: a) Cash and other liquid assets generated by income with which the firm can pay dividends. b) Net assets (assets minus liabilities) generated by income that the firm can distribute as dividends. c) Part of the firm’s owners’ claims to net assets of the firm. d) None of the above. e) More than one of the above. 2. If a firm uses the indirect method for the statement of cash flows (SCF), which of the following is true? (Indicate all true statements.) a) The SCF lists cash receipts from customers. b) The SCF shows cash spent for acquiring other firms in the financing section of the statement. c) The SCF shows stock issued to acquire other firms. d) The SCF shows the change in accounts receivable. 3. The accounting for inventories in the United States can be based on either LIFO or FIFO. Which of the following statements describes LIFO and FIFO accounting under U.S. GAAP? (Indicate all that apply.) a) LIFO inventory accounting always results in lower financial statement income. b) LIFO inventory accounting always reduces income taxes paid for a given period. c) A given firm must use either LIFO or FIFO for all its inventories; it is not legal under tax law to use LIFO for some inventories and FIFO for other inventories. d) A firm that uses LIFO must display the difference between costs of beginning and ending inventories as reported and the costs of inventories that would have been reported had the firm been using FIFO (or current cost). 4. Which of the following is true of the accounting for derivatives? (Indicate all that apply.) a) Derivatives always appear at fair value (market value) on the balance sheet. b) The accounting for derivatives under U.S. GAAP can induce volatility into earnings. c) By definition in U.S. GAAP accounting, derivatives are instruments that require large cash investments at inception. d) Derivatives can never be assets for accounting purposes. 5. Stock options granted to employees: a) Must be accounted for as compensation expense (like cash compensation payments made to employees). b) Are never accounted for as compensation expense. c) Can be structured to generate substantial tax savings for the employer, with the tax savings shown as a source of cash from operations in the employer’s statement of cash flows. d) Both b and c. Answers: 1) c 2) d only 3) d only 4) b only 5) c How, exactly, are you defining financial literacy? Financial literacy is the ability to understand the important accounting judgments management makes, why management makes them, and how management can use those judgments to manipulate financial statements. You’d think it would be a basic requirement on audit committees, but it’s unbelievably scarce. Look at a balance sheet. Every number but the date requires an estimate or judgment. What’s your cost of goods sold? It depends on how you value ending inventories. Managers will choose their inventory valuation method depending on how they want to manage or, some would say, manipulate income. One method increases cash flow by lowering current income tax payments and enables easy income manipulation by varying end-of-period purchases. Another method results in higher reported earnings per share. How can an audit committee meet its oversight responsibility if it doesn’t understand—or think to ask about—these types of judgments and the extent to which management has used its discretion to affect reported income? So, to be financially literate, every person on an audit committee should understand the transactions that require management to make important accounting judgments, the accounting issues management has to confront in explaining the transactions, the decisions management made and why, and the potential implications for financial reporting of management’s choices. Not everyone would agree that audit committee members need to know the nitty-gritty of financial reporting to do their job. But this isn’t nitty-gritty. Management needs to tell the SEC and the investment community, “These important accounting judgments affect our statements.” The audit committee had better understand these consequential judgments. But the group doesn’t need to comb through the details of decisions on individual uncollectible accounts, or the effectiveness of every cash flow hedge, when the company has many. Even without financial literacy, can’t the audit committee get the information it needs by grilling management? What good does it do to ask tough questions if you can’t evaluate the answers and ask the proper follow-ups? You might think being able to ask a tough question indicates an ability to grasp the answer. But I devised a “tough question” tool to see how well volunteer board members could differentiate between a CFO’s satisfactory and evasive answers to a straightforward question about the reserve for uncollectible accounts. The median number of correct responses among respondents was less than half. (See the exhibit “Tough Questions.”) Tough Questions Roman Weil designed this test to see how well board members could differentiate between a CFO’s satisfactory and evasive answers to a straightforward question. A member of the audit committee asks the CFO or auditor a tough question. You need to classify each of the following answers as: a) Unresponsive—a reply you might hear from a CFO who doesn’t know his business or is trying to trick you. b) OK as far as it goes but needs a follow-up question, which you must pose. c) Satisfactory and complete. “How do you know the reserve for uncollectible accounts is adequate?” 1. “I think it’s much more likely than not that the amount of cash and marketable securities is adequate to cover any cash shortage caused by customers not paying what they owe.” (a) (b) (c) 2. “I have checked the bad-debt expense for sales made this past period and found that amount reasonable.” (a) (b) (c) 3. “I have performed an aging of all accounts receivable and found that amount reasonable.” (a) (b) (c) 4. “I have performed an aging of accounts receivable for all sales this period and found that amount reasonable.” (a) (b) (c) 5. “The reserve amount bears the expected relation to the amount of the allowance for uncollectible accounts.” (a) (b) (c) 6. “We performed a detailed confirmation of receivables from customers whose accounts the firm wrote off as uncollectible this period and found the decisions suitable under the circumstances.” (a) (b) (c) 7. “I know the reserve was correct at the end of last period, and I checked the bad-debt expense for this period using a percentage of sales recommended for this class of customers by the top two credit-reporting agencies.” (a) (b) (c) Answers: 1. a (Many board members mistakenly think reserves have something to do with cash or other liquid assets; they don’t.) 2. b (Required follow-up question: What about the adequacy of the reserve allowance for sales made before this past period?) 3. c 4. b (Required follow-up question: What about the aging for the amounts uncollected at the start of the period?) 5. a 6. a 7. c So what does a board do about the problem? Stop assuming that general business savvy indicates an adequate knowledge of accounting to get by on the audit committee. It doesn’t. Quit appointing fellow CEOs to the audit committee just because they’re friends, and be wary of CFOs who have come up the career ladder as treasurers or investment bankers. Those aren’t career paths that necessarily teach much about accounting. Look for CFOs who have been controllers or auditors. Look among recently retired auditors for the financially literate. Encourage the audit committee to hire tutors, and remember that the amount of learning board members will do is inversely proportional to the number of people in the room. Board directors need to trust everyone else in the room before they will admit, “I don’t understand; tell me.” And a willingness to admit ignorance is required for learning.
