Nine Questions to Ask When Reading Proxies

Summarized by Ev Luecke


I thought this was an excellent article and have summarized for your
convenience. Due to the Sarbannes-Oxley Act the audit committees have come
under closer scrutiny to take their responsibilities seriously.
Read the biographies of the chair and other committee members.
They are all supposed to be knowledgeable in financial matters and the
chair is supposed to be a financial expert.  The proxy may formally
designate the chair as a financial expert.  This doesn't automatically
signal trouble, but if there was any creative accounting going on, it is
doubtful some of these people would recognize it, regardless of their
stellar qualifications in unrelated fields.

On the other hand, highly qualified committee members could be sleeping on
the job, as was the case with Enron, which had the dean of Stanford
Business School
on its audit committee.

How many times did the audit committee meet during the past year?

The numbers ranged from two to twelve in the proxies we looked at. Two is
woefully inadequate and twelve may be overkill. At a minimum, the
committee should be meeting quarterly with outside auditors, before
quarterly earnings are reported. Additional meetings may be required to
consult with the internal auditors to ascertain the adequacy of internal
controls. The proxy statement should also disclose whether the committee
met without members of management present so that frank and open
discussion can take place about the integrity of management's financial

How much are outside auditors being paid for nonaudit services? How does
it compare to the amount paid for audit services?

Enron was faulted for paying Arthur Andersen about as much in (highly
profitable) consulting fees as for (low-profit) audit services. Yet such
well-known companies as Cooper Tire and Rubber and Wachovia paid their
outside auditors nonaudit fees in amounts about equal to the amounts paid
for audit services. Most of these fees were for tax services, including
"tax planning," a service that the AICPA has vigorously fought to keep.
Nevertheless, with the recent revelations of highly questionable tax
strategies being peddled by some accounting firms (witness Sprint), it is
doubtful that the outside auditors could give an unbiased opinion on the
tax provision in a company's income statement when they were the ones who
computed it. The AICPA shouldn't take its victory lap yet as tax services
may end up being limited to tax preparation; tax planning and IRS audit
representation services being prohibited. Stay tuned to see if providing
tax services remains permissible.
One company shockingly revealed that it was still using its outside
auditor to perform internal auditing, even though that is now virtually

Did the audit fees increase substantially from one year to the next?

While the proxy statements don't reveal the reasons for a big increase,
this could be an indication that there were problems encountered which
required the auditors to extend the scope of their services.

Has the company changed auditors?

Companies are required to disclose when they change auditors and the
reason for the change if there was a disagreement over accounting
principles. In practice, management is usually too smart to do anything
that would cause the disclosure of a disagreement over accounting
principles. A CFO that is going "principles shopping" will simply let one
year's statements be issued and then carefully "interview" a successor who
will give the right answer to the question: "What does 2 + 2 equal?"
(answer: "What would you like it to equal?"). One proxy statement showed a
company changing auditors twice in three years. Even though no reason was
given, it still doesn't pass the smell test. The SEC should require
disclosure of the reasons for the change (such as . the auditors' staff
was inexperienced, the fees got too high, etc.), not just limited
disclosures of disagreements over accounting principles.


Are there any "reportable events?"

Did the auditors discover serious weaknesses in internal control (e.g.
company policy permitted the capitalization of expenditures that should
have been expensed, thus inflating income) or did they discover illegal

Are there related-party transactions?

One company rents its corporate headquarters and several of its branch
locations from a partnership controlled by the chairman and his family.
While these transactions are supposed to be conducted at arm's length,
their existence raises eyebrows. Another company lists loans between the
company and high-level corporate executives. Sarbanes-Oxley Section 402
forbids most personal loans to executives.

What are the components of executive compensation and how much is it?

This subject has been nearly beaten to death and the required disclosures
aren't close to being adequate. Nevertheless, wages are only one component
of executive compensation. Look in particular for severance pay and change
in control agreements. Are top executives being offered incentives to
leave or will they be generously rewarded if they fail? This is the
subject of a number of shareholder proposals that will be voted on at many
company shareholder meetings this year.
Read the Shareholder Proposals.

General Electric (with 13) is probably the winner for the most shareholder
proposals included in a proxy statement (we didn't perform an exhaustive
search, however.) Shareholders who make proposals at annual meetings are
often characterized as gadflies, crackpots, or worse. However,
institutional investors and others are making more and more proposals with
agendas worth serious consideration. Performance-based compensation,
concern about a company's environmental or safety record and issues raised
by labor organizations may be portents of future problems.
Since investors don't have heat-seeking missiles that will take them
directly to a company's problems, they will have to carefully look in the
proxy statements as well as the financial statements for some of these
indicators of corporate corpulence, thus avoiding the snake pit.

Have a Happy Holiday - Ev