McKenna’s Insights into Berkshire Hathaway

Francine McKenna isn’t afraid to take on the big four auditing firms or the rich and powerful. Look for her column, Accounting Watchdog at Forbes.com. The following is an extended excerpt from a recent post, The Berkshire Hathaway Corporate Governance Performance. “Buffett judges the investments he makes ruthlessly, but allows his operating companies to run on autopilot.” That decentralized structure allows plausible deniability when anything goes wrong.

I encourage reading the entire article and getting familiar with McKenna’s work. It is good to see such an expert willing to speak truth to power. As a Berkshire Hathaway shareowner, her analysis certainly makes me nervous and it is hard to imagine shareowners taking on such an iconic figure through governance initiatives successfully.

…Before leading the Treadway Commission, before the savings and loan scandals of the 1980’s, before Enron and the rest of the scandals of the 90’s such as WorldCom, Tyco, Adelphia, HealthSouth, and many others, James Treadway, SEC Commissioner, made a speech about financial fraud. His remarks specifically mentioned corporate structure, in particular a decentralized organizational structure, as a common characteristic of companies involved in financial fraud.

An excerpt of remarks by James Treadway to the Third Annual Southern Securities Institute, Miami Beach, Florida, April 8,1983

I refer to a decentralized corporate structure, with autonomous divisional management. Such a structure is intended to encourage responsibility, productivity, and therefore profits—all entirely laudable objectives. But the unfortunate corollary has been a lack of accountability.

The situation has been exacerbated when central headquarters has unilaterally set profit goals for a division or, without expressly stating goals, applied steady pressure for increased profits. Either way, the pressure has created an atmosphere in which falsification of books and records at middle and lower levels became possible, even predictable. This atmosphere has caused middle and lower level management and entire divisions to adopt the attitude that the outright falsification of book and records on a regular, on going, pervasive basis is an entirely appropriate way to achieve unrealistic profit objectives, as long as the falsifications get by the independent auditors, who are viewed as fair game to be deceived.

Treadway goes on to describe a company that’s almost an exact replica of Berkshire Hathaway. What’s most troubling is that nearly thirty years later there’s no excuse – lack of technology, real time communications, or specific regulatory requirements – for these conditions to still exist in a company of the size and systemic importance of Berkshire Hathaway. The weaknesses remain by design, not by default, which begs the question of whether they could serve an illegal or unethical purpose at any time.

Treadway’s speech goes on to describe eight characteristics of decentralized companies that promote lack of accountability and, potentially, the existence of financial fraud. I repeat them here, in italics, with a few comments after each related to Berkshire Hathaway. [I've left out McKenna critical comment.]

1.The divisions and subsidiaries were autonomous, with little or no oversight by headquarters, particularly in the areas of auditing, accounting, and internal controls.

2. Constant pressure was strongly exerted by distant top management on subsidiaries and divisions to achieve profit goals set unilaterally and arbitrarily by corporate headquarters.

3.  Communications between divisions and headquarters about the practicability of reaching established profit goals ranged from limited to non-existent.

4. Headquarters and top management created an atmosphere in which sales and marketing functions in the divisions we reviewed as more important than accounting and auditing.

5. That atmosphere caused divisional managers and personnel to believe that falsifying or “cooking the books” was the only way to achieve the profit demands, and that this was acceptable to headquarters. The divisional personnel engaged in the improper activities as part of an admitted” team effort.” In some instances, divisional employees stated that they believed it a “mortal sin not to meet the profit goals.

6. No employee involved received any direct personal benefit from theft, bribes, kickbacks, or diversion of assets.
7. The falsifications were large, simple, and direct. Expenses were improperly shifted from one accounting period to another. Goods ready for shipment, sometimes not even manufactured, were accounted for as sales in the current period, even though not actually shipped or manufactured until a succeeding period. False statements were made to auditors. Multiple sets of expense records were kept. Shipping invoices and bills were altered, with third parties sometimes enlisted to assist.
8. The falsifications were undetected by top management, not for brief periods of time, but for years and years. In short, the break-down was systemic.

Follow Francine McKenna on Twitter @retheauditors. I certainly do and I’ve added her re: The Auditors to my blogroll.  I haven’t seen anyone else explore the role, responsibility and regulation of the audit/accounting industry in the global capital markets with such independent insight as McKenna.

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