Northrop Grumman's Accounting Improves, But Problems Linger

| About: Northrop Grumman (NOC)

Northrop Grumman's (NYSE:NOC) financial results now show fewer signs of risky accounting, but the defense firm's corporate governance is far from perfect.

The company's financial statements reflect an AGR score of 42, indicating higher accounting and governance risk than 58% of companies. That's up significantly from the previous score of 10 we had discussed in July.

One change that contributed to the better score involves the company's treatment of its costs. Declines in selling, general and administrative expenses can reflect more efficient operations, but managers must decide on what appropriately counts toward producing goods sold as well as the timing of recognizing those expenses. For example, the salary of someone who makes software could be an asset until the product sells, when it becomes an expense -- but if the researcher is working on an early stage or unfruitful project, that salary is always an expense. This flexibility can result in disagreements about how to report financial results. As of December 2011, the trailing twelve month average of such costs at Northrop Grumman had amounted to $2.35 billion, up from $1.92 billion as of September 30, 2011, and down from $2.66 billion as of June 30, 2011. In recent quarters, however, these expenses have stabilized.

That said, Northrop Grumman continues to show warning signs of potential corporate governance issues. For example, after determining that CEO Wesley G. Bush's base salary was "anticipated to lag" the peer group median, the board concluded that he deserved an increase. His total summary compensation for 2011 climbed to $26.2 million, three times the median for other named executive officers at the company, and up 15% compared to fiscal 2010.

CEO pay, however, is all over the map. Lockheed Martin Corp.'s chairman and CEO Robert J. Stevens got $25.4 million that year. General Dynamics Corp.'s CEO and chairman Jay L. Johnson earned nearly $16.1 million. Meanwhile the CEO of BAE Systems P.L.C., Ian G. King, earned £2.4 million in December 2011, or around $3.9 million. Such differences reflect not only the revenues generated at each firm ($46.5 billion, $32.7 billion, and $28.8 billion, respectively in 2011) but also other variables such as regional standards for CEO compensation or the extent to which senior managers are supervised.

Indications are that Northrop Grumman's board should have more safeguards to ensure that Bush's power does not go unchecked. After Bush became CEO and president in January 2010, he took on the additional role of board chairman in July 2011- effectively becoming one of his own supervisors. The same day, the board designated Lewis W. Coleman its lead "independent" director. As the CFO of DreamWorks Animation, Coleman has limited time to carry out his duties, which include advising Bush and having the authority to call meetings among the independent directors. Moreover, the company paid him over $5.2 million in costs related to security protection in 2011 -- that included housing him in a more secure residence. Given that Coleman earns more from Northrop Grumman than some of its employees do, his independence seems unlikely.

Whether the board is supervising Bush objectively or not, at least the company fixed some of the red flags in its financial statements in recent months.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by a financial reporter at GMI. The reporter has no business relationship with any company whose stock is mentioned in this article. Nobody paid GMI to write this article on his or her behalf.

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