Gobierno Corporativo y Divulgaci ó n Financiera Como Armas Competitivas

1. Gobierno Corporativo y Divulgación Financiera Como Armas Competitivas Un Vistazo a las Nuevas Pautas y las Oportunidades que Ya Existen John C. Edmunds Profesor de Finanzas Babson College Institute for Latin American Business

2. Background • Thomas McDermott • Executive in Residence, Institute for Latin American Business, Babson College • Public and private company boards of directors; audit committees • Community organization boards • Accion International; Endeavor Global; LASPAU Harvard • Ernst & Young: 39 years, including • New England Region Managing Partner • South America Region Managing Partner (18 offices across SA)

3. Overview • Corporate Governance & Value Creation • Financial Reporting • Board Oversight – Financial Reporting • Financial Reporting Complexities • Accounting Principles • Financial Reporting – The Players • What Can Go Wrong? Who is to Blame? Continued

4. Overview, Continued • Information Useful to Board Members • Telltale Signs of Looming Problems • Managing Earnings • Examples of Abusive Earnings Management • Detecting Abusive Earnings Management • Yellow & Red Warning Signs • Independent Auditors – Do They Make a Difference? • Summary

5. Corporate Governance and Value Creation • Value Creation: When business earns more on its investment than cost of capital. Management formulates strategies to achieve this. • Governance: Board of Directors creates value by governing well. Vital to capital formation and health capital markets. • Avoiding meltdowns (Enron, WorldCom, Tyco, Xerox, Global Crossing, Lucent) • Oversight of financial reporting (accuracy, balance, fairness, credibility, transparency) • Conflicts/related party transactions • Understanding key business risks/opportunities • Judging quality, depth, integrity of management

6. Financial Reporting • Outside constituencies: shareholders, regulators, securities exchanges • Internal management and board (monthly): operating results, forecast • Well-understood reporting: accurate & full disclosure, timely, delivered by competent management, accompanied by audits (external & internal), sense of integrity throughout

7. Board Oversight – Financial Reporting • Audit Committee • Independent, outside board members • Top quality; financial experience • Critical eye; healthy skepticism • Board Members • Authority delegated to AC; responsibility is not delegated

8. Financial Reporting Complexities • Concept of profit… more than cash • In short term, financial reporting assists to: • Manage the business • Judge performance • Measure return on investment • Raise capital • Calculate tax on income • Cash basis will not work in short term

9. Financial Reporting Complexities , Continued • Accrual accounting • At core of most financial reporting complexities • Net income – primary performance indicator • “Expectations” of future cash consequences of current events • Often subjective; relies on management assumptions • Methods/Conventions • Depreciation; inventory valuation; accounts receivable; deferred income; prepaid expenses; accrued revenue/expense • Choosing from among available conventions • Methods within methods • Specific industries/transactions • Some controversial: stock options, deferred income tax, foreign currency items, inflation

10. Accounting Principles/Conventions • GAAP • Most formulated by FASB (IAS), standard-setting body (also GAAS) • GAAP relies on such concepts as historical cost, lower of cost or market; GAAP is not a quest for true current underlying market values or economic worth • GAAP is constantly changing to fit changing business circumstances, securities, technologies, etc..

11. Accounting Principles/Conventions • GAAP, continued • GAAP changes are to limit distortions, put barriers on management, address normal optimistic bias, address new transactions • Super-conservative rules force markets to redesign transactions • Reasonable amount of flexibility (“wiggle room”) within GAAP • “Little conservative” is usually where you want to be

12. Quick Summary • Financial reporting, done well, is the most widely available data on public company economic movement. • Accounting and financial reporting is not precise. Not math or physics. • Often relies heavily on “good judgement” and well-documented “best efforts.” • Some cardinal rules: • Management, Financial Management, Board must be smart, experienced, high integrity people. • Fairness, consistency, materiality, honesty, wisdom.

13. Financial Reporting Has Many Players • Management (CEO, CFO) • Board (AC, AC Chair) • Internal Audit • Key Operating Management (eg. loan officers) • Regulators: SEC, Banking, Stock Exchanges, FASB, PCOB • Outside Independent Auditors • Security Analysts • Investors & Other Users

14. What Can Go Wrong? Who is to Blame? • Plenty of people to blame? Wrong! • Major focus of blame: Board, AC, Management, Auditors (in that order). • Anything about financial statements, financial reporting process you do not understand, talk about it with Senior Management, Board, AC. • Anything about competence/integrity; get the Board to address it. • There are two ways to exit (advice counsel): silent or noisy.

15. Information Useful to Board Members • A ton of checklists and other materials available to AC and Board • Law firms, independent auditors, universities. • Books: • “The financial numbers game: Detecting creative accounting practices.” Mulford and Comiskey • “Financial Statement Analysis: A practical guide.” Fridson and Alvarez • “Profits You Can Trust: Spotting and surviving accounting landmines.” Sherman, Young, Collingwood. • “Business Analysis & Valuation: Using financial statements.” Palepu, Healey, Bernard. • “Corporate Governance.” Kim and Nofsinger. • Consultants to Boards

16. Telltale Signs of Looming Problems in the Financial Reporting Process • Process • Awkward • Delayed or “last minute” • Hard to reconcile shareholder, management, budget information • People Limitations • Smarts and experience • Depth (eg. Compliance, upcoming change) • Human values, reputation

17. Telltale Signs of Looming Problems in the Financial Reporting Process • Numbers • Always on budget • Variations from budget not well-defined • Profile ratios and metrics to track & compare: price/earnings, price/EBITDA, gross margin, operating margin, receivable/inventory intensity, cash flow ratios, tax rates, debt ratios, capital ratios, capitalized software, headcount, other companies in the business.

18. Telltale Signs of Looming Problems in the Financial Reporting Process • Accounting Policies • Revenue recognition/major impact • Changes (changed facts or managing earnings) • Lives, estimates, residual value, rates of completion, asset impairment • You can not see all from where you sit (eg. Profit taking, loan loss reserves) • External/internal auditing

19. Telltale Signs of Looming Problems in the Financial Reporting Process • Footnotes • Customary competitive constraints; proprietary segment information • Contingencies (eg. New litigation, tax claims, environmental issues) • Out-of-control conditions • Patent, trademark, regulatory approvals • Other information • Regulator reporting to shareholders (SEC) • Management discussion & analysis • 10K Parts I and II (wealth of info) • Quarterly analyst meetings via Internet

20. Managing Earnings • Wall Street is unforgiving when businesses miss quarterly estimates • Must say within GAAP and full disclosure • Some flexibility or “wiggle room” permitted – selecting from among alternatives and interpreting standards • Abusive earnings management • Smooths earnings and trends • Volatility obscured • Hides negatives • Often hard to detect without audit • Self-defeating in the long run; usually will eventually reach the surface

21. Managing Earnings, cont. • Levitt: “Gray areas where accounting is perverted; where managers cut corners; black lies beyond gray.” • Management may have a more personal agenda. • Bonus issues, using budget targets in employee compensation formulas.

22. Examples of Abusive Earnings Management • Not a lot known about how, why and extent practiced • Recent survey reported 227 examples of abusive earnings management techniques observed by financial managements.

23. Examples of Abusive Earnings Management, cont. • Timing of operating expense • Big bath charges and cookie jar reserves • “Restructuring accruals” revenue recognition • “Real” actions • Inventory accounting (increasingly not in new economy) • Changing in accounting policies/practices • “Rainy day” reserves

24. Examples of Abusive Earnings Management, cont. • Stretching & going beyond flexibility inherent in GAAP • Interperiod shifting revenue/expense • Acceleration/deceleration sales at month end • Books held open several days after close of year for additional sales (fraud) • Goods shipped to customer who did not place an order (fraud) • False entries, sometimes over several years (fraud) • Revenue recognized from consignment, before ultimate sale (non GAAP) • Investment gain to offset special charge from asset write-down (GAAP; OK with disclosure both)

25. Detecting Abusive Earnings Management • The same survey: 190 possible detection techniques • Often difficult • Continues many years without detection • Active participation/collusion by top management • Active efforts to subvert activities of independent auditor • Detection often not conclusive; yellow flags, not red • Some debate continues on whether earnings management is harmful versus helpful

26. Yellow/Red Lights: Keep Your Eyes Open! • Special Purpose Entities (SPE), Business Alliances, Joint Ventures, via Corporate Forms, via Contract Agreement, Related Party Transactions: • New economy • Increasingly popular • Often complex structures • Issues of ownership, control, significant influence • Begin as immaterial and zero disclosure • Moving off the financials • Manufacturing assets, debt, R&D spending

27. Yellow/Red Lights: Keep Your Eyes Open! (cont.) • Goodwill; global or per transaction • Market declines of long-term holdings • Sudden inventory adjustments • Invasion LIFO pools • Contract claims estimates • Completion estimates • Environment obligations • Change in pension accrual assumptions

28. Yellow/Red Lights: Keep Your Eyes Open! (cont.) • Purchase price allocation (earnings hits, acquired R&D, Goodwill) • Software development (aggressive capitalization and extended amortization) • Financial derivatives/hedge classifications • Acceleration of advertising spending, R&D spending • Press release terms such as “core net earnings” and other non-GAAP presentations, including “pro-forma” displays other than from business combinations/discontinuations. Beware.

29. Independent Audits – Do They Make a Difference? • “Inside Arthur Andersen: Shifting values, unexpected consequences.” Squires, Smith, McDougall, Yeack. • “Rules cannot fully replace personal integrity, or remove the inherent conflict between serving the public and maintaining profitability.”

30. Summary