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Gobierno Corporativo y Divulgaci ó n 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. Background. Thomas McDermott

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gobierno corporativo y divulgaci n financiera como armas competitivas

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

background
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)
overview
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

overview continued
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
corporate governance and value creation
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
financial reporting
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
board oversight financial reporting
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
financial reporting complexities
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
financial reporting complexities continued
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
accounting principles conventions
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..
accounting principles conventions1
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
quick summary
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.
financial reporting has many players
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
what can go wrong who is to blame
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.
information useful to board members
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
telltale signs of looming problems in the financial reporting process
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
telltale signs of looming problems in the financial reporting process1
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.
telltale signs of looming problems in the financial reporting process2
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
telltale signs of looming problems in the financial reporting process3
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
managing earnings
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
managing earnings cont
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.
examples of abusive earnings management
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.
examples of abusive earnings management cont
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
examples of abusive earnings management cont1
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)
detecting abusive earnings management
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
yellow red lights keep your eyes open
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
yellow red lights keep your eyes open cont
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
yellow red lights keep your eyes open cont1
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.
independent audits do they make a difference
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.”