There’s no turning back now. This month, some 7,000 listed European companies are scheduled to start using a single set of international financial-reporting standards — whether they are ready or not. The new IFRS rules must be adopted by year-end, including those related to hedge accounting and fair value that met fierce opposition.
Sir David Tweedie, chairman of the International Accounting Standards Board, believes the time is right for the European Union to have one accounting language. As he told CFO last year, a single language will mean much more than financial transparency. “What we are really talking about is inward investment, growth, employment, and world trade,” he said. “It is not about arcane bookkeeping matters.”
Those bookkeeping matters, however, have not been easy to decipher. It is estimated that at least 500 companies in the United Kingdom, for example, are not ready for the rules introduction. Even more worrisome is that investors and analysts are not prepared. A November KPMG survey revealed that 40 percent of the 100 analysts surveyed said that their knowledge of the new standards was “poor.”
How the standards will affect financials won’t be known until the first interim reports are issued later in the year. But there will be a mixed bag. German chemical giant BASF AG has already revealed that the new rules on goodwill could add about €200 million to its net profit, while L’Oreal SA’s net worth could be reduced by €1.8 billion.
What the European experience will mean for the convergence of U.S. and international standards — slated to be in place between 2007 and 2008 — is also unclear. It may be the “handwriting on the wall” for what the future holds for U.S. companies, says Paul Bahnson, a professor of accountancy at Boise State University. But one main difference, says April Mackenzie, director of international financial reporting at Grant Thornton LLP, is that Europe is experiencing “a big bang,” whereas U.S. convergence will be “more like a creep.”
Still, observers strongly recommend that U.S. companies pay close attention to the European transition — a task that might prove difficult, says Dennis Beresford, former chairman of the Financial Accounting Standards Board. With all that U.S. CFOs have to do — Section 404 of Sarbanes-Oxley, accelerated reporting, expensing stock options — addressing future convergence is too overwhelming. “It may be intellectually interesting,” says Beresford, now an accounting professor at the University of Georgia, “but [finance executives] don’t have time right now to think about something so long term.” —Lori Calabro
Grounded to a Halt?
More executives may consider flying coach this year or even taking the train, thanks to a provision of the new tax bill, the American Jobs Creation Act of 2004.
That provision will change the way companies account for employees’ personal use of corporate aircraft. In the past, personal use of a company plane was considered a taxable source of compensation to the executive, and corporations were entitled to deduct the full cost of operating the aircraft on that flight. In the new law, however, the corporation’s deduction is limited to the amount the employee includes in income.
Hank Gutman, a principal at KPMG, notes that the new tax will increase the cost of operating a corporate air fleet. But he doesn’t believe it will totally discourage executives from using planes for personal reasons — only that cost implications will be examined.
But Louis M. Meiners Jr., president of Advocate Aircraft Taxation Co., contends the provision is already curtailing such travel. And, he says, the rule conflicts with federal aviation regulations that “prohibit employees from reimbursing employers” for air travel.
The government estimates the provision will add an extra $2.3 million in taxes in the next decade.
Give It Back!
State regulators are becoming significantly more aggressive in their attempts to rein in “obscene” executive-severance packages — so-called golden parachutes. But are their actions justifiable or simply political?
California insurance commissioner John Garamendi recently negotiated $265 million in givebacks from Anthem Inc., the fifth-largest publicly traded health-insurance company in the country, as a condition of his approval of its merger with WellPoint Health Networks Inc. The total “undertakings,” as the givebacks are called, are on top of financial commitments already agreed to by Anthem, and will equal the amount that WellPoint executives were due to receive as part of the deal, including more than $70 million for WellPoint CEO Leonard Shaeffer.
Garamendi initially blocked the deal in July because it was “very bad for the policyholders of California.” The projected $4 billion in acquisition costs for the $16.4 billion stock-plus-cash deal, he explains, could be paid off only by raising premiums in California — a move he opposed. He also vociferously objected to the golden parachutes due to senior WellPoint executives. “The executive compensation is gross and obnoxious,” says Garamendi. “Seventy million is excessive. That’s insurance policies for 50,000 children. Are you saying Shaeffer is worth 50,000 children? Not in the world that I live in.”
Such strident criticism may be growing among regulators. In mid-November, the Rhode Island Department of Business Regulation turned down a 17 percent rate increase request by Blue Cross & Blue Shield of Rhode Island. The company claimed it needed the increase because it had a reserve deficiency in one of its insurance programs. The department officials shot back that the company would have been able to cover the deficiency if it hadn’t paid its CEO a $3.1 million severance package.
Other state officials are less sanguine. Timothy Cahill, treasurer of the Commonwealth of Massachusetts, states that executive compensation must be evaluated in the context of each deal. “If you’re creating value, you deserve to benefit from it,” says Cahill, who as chairman of the commonwealth’s pension plan oversees 21 million shares of Anthem and WellPoint. Moreover, he says, “we have to be careful as elected officials, regulators, or public officials because sometimes these kinds of moves look like sour grapes. We make public-sector salaries, and we’re weighing in on what someone in the private sector can make.” —Kris Frieswick
Go Directly to Cash
Of all the recent financial-reporting reforms, Securities and Exchange Commission chief accountant Donald Nicolaisen thinks the most important has yet to be proposed: requiring companies to use the direct method to report their cash flow.
At a November conference hosted by Financial Executives International, Nicolaisen said that despite Sarbanes-Oxley and the slew of new rules issued by the Financial Accounting Standards Board, corporate efforts to improve reporting have “fallen far short” of his expectations. “The single thing in my view that would go furthest toward improving disclosure,” he said, would be to mandate direct-method accounting.
The direct method calculates operating cash flow as a product of actual cash flows in and out — collections from customers, cash payments to suppliers, and so on. The indirect method, by contrast, arrives at that figure by adjusting net income for noncash expenses (such as depreciation and amortization), accruals, deferrals, and changes in working-capital accounts. Although both produce the same number, “the indirect method can hide a multitude of sins,” says Charles Mulford, an accounting professor at the Georgia Institute of Technology.
Still, the indirect method has always been the method of choice for most companies. Back in 1987, when FAS 95 established standards for cash-flow reporting, FASB left the indirect method as an alternative, bowing to corporate concerns about the expense of tracking all cash items, recalls Grant Thornton CEO Ed Nusbaum. And since companies using the direct method must provide a reconciliation to net income using the indirect method anyway, says Mulford, it’s no surprise that most simply continued to use the latter.
To date, Nicolaisen has never directly suggested that the SEC or FASB change the requirement. At the November conference, however, he did remark that “the status quo is not acceptable” and “there’s more that we have to do.” The question then, says Nusbaum, who is also a member of FASB’s advisory council, is whether analysts and other financial-statement users really want to make the change.
Still, the cash-flow methods may soon find their way to the table. “This is a back-burner item that is slowly moving forward,” says Mulford. —Tim Reason
Where’s the Coverage?
If you thought equity analysts weren’t paying enough attention to your company during the gold-rush days of the late 1990s, we’ve got bad news. Although the number of equity analysts in the United States has climbed 7.5 percent since 2003 — up to 3,207 from 2,983 a year earlier — that number is still 9.5 percent lower than it was during 2000, according to data released by StarMine, an analyst-research firm based in San Francisco.
This means that there are fewer companies being covered by analysts today (4,508) than at any time since 1995. To add insult to injury, the analysts left standing are also covering more tickers per person, 8.6. Last year was the second consecutive one in which that figure went up, rebounding from a six-year decline that started in 1996 (when it hit 11 tickers per analyst). This data shows that for small- and midcap public companies that are already grappling for coverage, things will undoubtedly get worse before they get better. And for those receiving coverage, quality will probably not rise as analysts struggle with an increasing coverage universe.
The problem, says StarMine vice president David Lichtblau, is that many of the new analyst positions are with smaller and boutique research firms, not the larger investment-bank research houses, where a deeper bench and more experience often compensate for higher workloads. That fact alone may signal a potential drop in the overall quality of equity analysis.
“As the number of companies an individual covers increases, something has to give,” says Rich Wyler, head of global public relations at the CFA Institute, an association for investment professionals. “The depth of the research decreases, the frequency of updates decreases, the quality decreases, or some combination of those. Every human has their limits.”
Many research analysts have apparently reached theirs: a CFA Institute study recently revealed that 40 percent of equity analysts polled expressed dissatisfaction with the number of hours they work, although 79 percent expressed satisfaction with the work itself.
Things are far worse overseas, however, as investment banks take a hatchet to their research divisions. The number of analysts in developed European countries, for instance, has dropped 13.3 percent since 2003, says StarMine. —K.F.
The idea has been around for decades: a public marketplace for private-company stock. Now Washington, D.C.-based Entrex Inc. claims to have created such a market through a partnership sanctioned by the Securities and Exchange Commission.
According to Entrex founder Stephen H. Watkins, the market has been set up as a coordinated effort with Niphix, a brokerage firm that operates an alternative online-trading system. Entrex provides the reporting infrastructure — as EDGAR does for the public exchange — while Niphix serves as the actual exchange.
“The fourth market,” as it is called by its creators, is in its initial stage. Although the model has been approved by the SEC, Watkins says the marketplace will take some 2 to 5 years to establish itself. “We are where Nasdaq was [originally],” he says. “It took them 10 years to create an exchange. We are just beginning — we’ve got to get companies to buy in; we’ve got to get the capital markets to buy in.”
Part of the appeal, says Watkins, is that the fourth market will provide exposure that private firms need to raise capital. “It will [provide] an increased valuation for companies because of the exposure, credibility, and liquidity that the market brings to shareholders,” he says.
But creating a market for private companies has hurdles. “Every couple of years, somebody comes around with the same idea,” says Georgetown University professor James Angel. But, he notes, “to be a public company, you need to be big enough to justify the overhead of all the reporting requirements of issuing stock.” In addition, “from a markets perspective, you have to be big enough to make it worth looking at by institutional investors.”
Although it’s too soon to pass judgment, Angel says Entrex might have a chance: “You never know; lots of big operations started small.” —Wilson Lièvano
Tiptoe Through the New Regs
If corporate tax directors were to adopt a mantra, it might very well be: Tread lightly.
In fact, according to a new study by Ernst & Young LLP, 44 percent of tax directors say their companies have become more risk averse in the past two years. Most of the 354 tax directors surveyed reported spending more time on compliance, and 75 percent said risk management was a criterion upon which their performance was measured.
“In the ’90s, tax directors were more focused on the value they could bring by lowering effective cash rates and increasing cash flow,” says Mark Weinberger, vice chairman of E&Y’s tax service. “As good as a tax director is at reducing the overall tax rate, if he does something that might be legal but that hurts the company’s reputation, it could undo all the value created.”
How companies measure tax-director performance.
|Success in dealing with tax authorities||81%|
|Tax risk management||75%|
|Timeliness of compliance||64%|
|Effective tax rate||48%|
|Source: Ernst & Young LLP|
As a result of this more-conservative bent, some tax initiatives have taken a back seat. “We’re spending more time on compliance, documentation, and disclosure, and a lot less time on tax planning,” says one tax director at a Fortune 500 company, who estimates she spent 10 times as long on 2004’s annual close as she did in the past. Moreover, says Bruce Sedlock, director of taxes and asset accounting at $3 billion Allegheny Energy Inc., tax managers are being much more cautious. “Prior to Sarbanes-Oxley, tax directors might have been more likely to make estimates, but now we’re more precise in accounting for reserves,” he says.
Tax directors are also finding their internal influence increasing. To make sure they’re pursuing the appropriate tax policies, many are presenting their positions to not only the CFO but also the CEO and the board. Nearly half of respondents said they receive “active direction” from the audit committee.
John Leahy, finance chief at the $900 million technology and business consulting firm Keane Inc., in Boston, confirms that he has seen changes in the tax-director role, although he says the shifts go hand in hand with “so much else we’re dealing with in regard to good corporate governance, compliance, and transparency.”
Still, there’s no denying that reducing the effective tax rate remains a priority, says Sedlock: “A lot more companies are experiencing operating losses, and in times like that people become more aggressive about generating cash.” But the process, says Leahy, “is complicated by “a whole lot more scrutiny.” —Kate O’Sullivan
The Securities and Exchange Commission has put companies and their finance executives on notice yet again, this time raising a red flag about pension accounting.
Since October, the SEC has been examining pension plans at six companies with large pension liabilities: General Motors, Ford Motor, Boeing, Navistar International, Northwest Airlines, and Delphi. Depending on what is found, the initiative could expand. “This is just the tip of the iceberg,” predicts Jeff Mamorsky, a senior partner at the New York law office of Greenberg Traurig LLP.
At issue are the assumptions firms use to calculate pension returns. According to SEC spokesman John Nester, when pension accounting was identified as a target area two years ago, “we made it clear to companies that they had to put genuine thought into the assumptions they put in their financials. Boilerplate does not suffice.”
The expectations for stock-market return are of particular concern, as the SEC suspects many companies continue to assume certain annual returns even in down years. Company executives also make estimates about the size, age, and mortality rate of their pension-recipient pools. With optimistic assumptions, companies can reduce the pension liabilities shown in their financials and potentially manipulate earnings.
Finance executives stand by their processes. In a conference call in October, The Boeing Co. CFO James Bell said the SEC has not accused the company of any wrongdoing. “They made it pretty obvious in their request letter that they don’t suspect that there are any issues,” said Bell. “We believe that our processes and the assumptions that we have in place and the discipline that we have in creating those assumptions will stand up well.”
But Mamorsky points out that one main problem is that “there’s a very wide range of assumptions.” He suggests that CFOs review their own pension-accounting assumptions to make sure they are appropriate. Finance executives should compare mortality and turnover assumptions with actual rates for the past three to five years and create a model to determine how assets and liabilities would be affected by hypothetical future events, for example. —K.O’S.