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
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Thomas McDermott
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Executive in Residence, Institute for Latin American
Business, Babson College
Public and private company boards of directors;
audit committees
Community organization boards
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Accion International; Endeavor Global; LASPAU Harvard
Ernst & Young: 39 years, including
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New England Region Managing Partner
South America Region Managing Partner (18 offices
across SA)
Overview
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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
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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
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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.
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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
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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
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Audit Committee
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Independent, outside board members
Top quality; financial experience
Critical eye; healthy skepticism
Board Members
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Authority delegated to AC; responsibility is not
delegated
Financial Reporting Complexities
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Concept of profit… more than cash
In short term, financial reporting assists to:
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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
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Accrual accounting
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Methods/Conventions
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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
Depreciation; inventory valuation; accounts receivable;
deferred income; prepaid expenses; accrued revenue/expense
Choosing from among available conventions
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Methods within methods
Specific industries/transactions
Some controversial: stock options, deferred income tax,
foreign currency items, inflation
Accounting Principles/Conventions
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GAAP
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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/Conventions
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GAAP, continued
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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
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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 welldocumented “best efforts.”
Some cardinal rules:
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Management, Financial Management, Board must be smart,
experienced, high integrity people.
Fairness, consistency, materiality, honesty, wisdom.
Financial Reporting Has Many
Players
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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?
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Plenty of people to blame? Wrong!
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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
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A ton of checklists and other materials available to AC
and Board
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Books:
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Law firms, independent auditors, universities.
“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
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Process
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Awkward
Delayed or “last minute”
Hard to reconcile shareholder, management, budget
information
People Limitations
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Smarts and experience
Depth (eg. Compliance, upcoming change)
Human values, reputation
Telltale Signs of Looming Problems
in the Financial Reporting Process
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Numbers
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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 Process
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Accounting Policies
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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 Process
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Footnotes
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Customary competitive constraints; proprietary segment
information
Contingencies (eg. New litigation, tax claims, environmental
issues)
Out-of-control conditions
Patent, trademark, regulatory approvals
Other information
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Regulator reporting to shareholders (SEC)
Management discussion & analysis
10K Parts I and II (wealth of info)
Quarterly analyst meetings via Internet
Managing Earnings
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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
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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.
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Levitt: “Gray areas where accounting is
perverted; where managers cut corners; black
lies beyond gray.”
Management may have a more personal
agenda.
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Bonus issues, using budget targets in employee
compensation formulas.
Examples of Abusive Earnings
Management
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Not a lot known about how, why and extent
practiced
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Recent survey reported 227 examples of
abusive earnings management techniques
observed by financial managements.
Examples of Abusive Earnings
Management, cont.
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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, cont.
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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
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The same survey: 190 possible detection
techniques
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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!
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Special Purpose Entities (SPE), Business Alliances,
Joint Ventures, via Corporate Forms, via Contract
Agreement, Related Party Transactions:
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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.)
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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! (cont.)
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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?
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“Inside Arthur Andersen: Shifting values,
unexpected consequences.” Squires, Smith,
McDougall, Yeack.
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“Rules cannot fully replace personal integrity, or
remove the inherent conflict between serving the
public and maintaining profitability.”
Summary