Emerging Issues in Finance

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• Emerging Issues in Finance
• What Keeps Me Up At Night?
• Philip Livingston
• December 20, 2005

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Issues Around 404

• COST, COST, COST
• New FASB standards and other regulatory
  obligations
• Outpouring of concern when ED on Uncertain Tax
  Provisions was proposed for year end
• Complexity of standards and impact on 404
  processes
• Companies continue to modify their installations
  of IT systems late in the year due to concerns of
  AS2 implications
• Continuing lack of judgment in evaluation of
  deficiencies
• More leadership needed from companies and
  accounting firms
• Inexperienced staff need guidance and sense of
  scope and risk

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FEI SOX 404 Implementation Practices of
Leading Companies

• Organization Structure
• Enterprise-wide initiative through tone at the
  top
• Start early, involve many and communicate
• Finance takes the lead controllership or
  internal audit
• Clearly define roles and responsibilities
• Separate documentation and testing
• Robust training and education
• Scope, Documentation and Testing
• Self-assessment as the foundation
• Risk-based approach to scope
• Formalize and standardize documentation and
  testing
• Incorporate internal controls reviews in MA due
  diligence

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Big Picture Lessons from 404 Implementations

• Too much work on transaction level testing
• Dont tolerate ridiculous claims of control
  failure
• Contol documents in a file lacked a total when
  all the detail was listed in the schedule and the
  total was correct on the summary
• Dont be forced into a best practices cramdown.
  
• Stay focused on how controls and control failures
  impact the financial statements
• Assess the total time spent on the various parts
  of the control system
• Dont spend half the effort on IT!

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Step Back How Many Controls Reasonable

• Some companies came up with 10,000 controls
• Lack of discipline in the process and lack of
  scope
• I argue that even the biggest companies cant
  have more than 100
• KEY CONTROLS
• FAILURE RISK COULD REALLY PRODUCE A REASONABLE
  CHANCE OF FINANCIAL STATEMENT MISSTATEMENT
• THIS MENTALITY WILL GET US TO THE INTENDED
  PURPOSE OF THE REQUIREMENT

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How to Make Internal Control Compliance
Sustainable and Efficient

• AUTOMATE, AUTOMATE, AUTOMATE!
• Focus on STRENGTHENING INTERNAL CONTROL
• Move beyond a compliance mentality
• 2004 proved that a pure compliance mentality is a
  disaster
• Build it in, dont bolt it on!
• Focus on testing ONLY key controls, do less
  transaction testing
• Build a Sensitive Transaction monitoring
  process
• Define high risk transactions in a policy that
  leaves little to judgment
• Define an extended approval and sign off process
  for these
• Like deal desk in the software world
• Certain transactions related parties and those
  involving executives may need to be elevated to
  the external auditor and audit committee
• Consider Harvey Pitts idea forensic audits
  every three years

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New Era In Stock Compensation

• 123 R - Accounting advantages of stock options
• Time to rethink stock compensation
• A few simple ideas
• Reduce the option exercise life to FIVE years
• Accounting expense about 30 less
• Convert the option plans to Stock Appreciation
  Rights Plans
• Economic dilution to shareholders significantly
  reduced

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Simplifying Financial Reporting

• Need to make financial statements READABLE and
  FUNCTIONAL for the INVESTOR
• Tables and charts, not text
• No elevator music!
• Real business issues and trends
• End of hard copy reports is in sight
• TECHNOLOGY! TECHNOLOGY! TECHNOLOGY!

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Escalating Audit Fees and Quality of Audits

• Escalating Audit Fees
• Quality of audits not improving
• Concentration of audit firms
• Talent pool severely strained by systemic changes

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Transactions with Executives

• Recent charges filed against Conrad Black allege
• An acquisition required non-compete payments be
  paid to the top executives
• Many of these cases are simply low-tech theft.
  No better than the guy that robs the local Seven
  Eleven. They should be treated that way.

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Revenue Recognition

• 60 of restatements historically from revenue
  recognition issues
• Usually, silly timing issues brought about by
  earnings pressure
• Lack of PRACTICAL, but formalized, policies
• Software industry particularly difficult

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Other High Risk Areas

• Financial Close Process
• Related Party Transactions
• Account Reconciliations
• Transactions Centered in Critical Accounting
  Policies
• Segregation of Duties
• Capitalization policies
• Variances in budget and forecasts to actuals

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SECs List of Common Fraud Schemes

• Premature revenue recognition
• Excess reserves to smooth earnings
• Improper accounting for vendor rebates
• Improper capitalized costs
• Changing estimates to make the numbers
• Top-side and period end manual journal entries
• Earnings management

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Real Promotion of Ethical Conduct

• We still arent doing enough here
• Employees need to know we are serious about
  snuffing out unacceptable behavior
• Communication must be repeated and come from the
  top
• Companies largely doing the least amount required

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Capital Allocation

• Acquisitions
• Do they hit the pre-deal projections?
• Do we get the synergies we projected?
• Does the return generate net shareholder value or
  destroy shareholder value?
• Capital expenditures
• New capacity really needed?
• Cost savings really materialize?
• Positive or negative IRR
• Share Buybacks
• Great balancer in capital allocation equation

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Bottom Line

• Clean, crisp financial reporting more valuable
  than ever
• Investors clearly avoiding messy, complicated
  companies.
• Premium valuations for companies that have clear
  business models and clear financial reporting.
• Ability of financial officers to impact
  shareholder value, greater than ever.

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