Gobierno Corporativo y Divulgaci

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

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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)

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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

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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

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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

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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

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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

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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

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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..

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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

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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.

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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

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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.

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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

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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

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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.

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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

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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

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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

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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.

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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.

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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

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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)

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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

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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, RD spending

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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

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Yellow/Red Lights Keep Your Eyes Open! (cont.)

• Purchase price allocation (earnings hits,
  acquired RD, Goodwill)
• Software development (aggressive capitalization
  and extended amortization)
• Financial derivatives/hedge classifications
• Acceleration of advertising spending, RD
  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.

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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.

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Summary