When Thomas Kuhn first coined the phrase “paradigm shift” in The Structure of Scientific Revolutions, he used it to describe the effect of fundamental changes in scientific assumptions. But such radical deviations have shaped other disciplines, including finance.
Hyperbole? Consider this: 20 years ago, risk management involved buying insurance, not guarding against terrorist attacks. Competition from overseas meant Japan, not China. Two decades back, CFO magazine wrote about the vexations wrought by FAS 87; these days, Sarbanes-Oxley can make pension accounting look like a walk in the park. And finally, the idea of a finance executive being a strategic partner was just that — an idea.
Presented on the following pages are the 20 events that most altered the practice of corporate finance since CFO magazine first began reporting on it in 1985. Taken together, they offer powerful evidence of just how much, and why, the CFO’s world has evolved.
A World Transformed
The tragic events of September 11, 2001, forced companies to reckon with the now-imaginable risk that a terrorist act could affect their employees and operations. CFOs rewrote their companies’ disaster-recovery plans, while security chiefs prepared for the possibility of bombs and bioweapons. Office buildings were walled off with Jersey barriers and outfitted with state-of-the-art surveillance systems.
Business travel became an ordeal, as air passengers lined up to be patted down. International supply chains slowed as Customs sought to secure the country’s borders. The new Department of Homeland Security issued color-coded terrorism alerts, adding to the general unease. Meanwhile, the Iraq war, deeply unpopular in Europe, did nothing to calm transatlantic trade tensions. As the deadly occupation dragged on, the price of oil soared to a record $50 a barrel.
No further terrorist attacks have occurred on U.S. soil. But Americans may never again feel as secure as they did before that sunny September morning.
From Here to There
Companies have been offshoring — loosely defined as relocating domestic jobs to lower-cost overseas locations — for decades. In the 1990s, U.S. manufacturers sent assembly work to Mexican maquiladoras. They also outsourced back-office functions to other U.S. firms. But not until the Y2K crisis did the two trends mesh. The skill of the Indian programmers who fixed code — not only round-the-clock, but cheaply and efficiently — set the stage for a wave of IT offshoring.
The offshoring trickle has since become a steady flow. Two years ago, Forrester Research predicted that 3.3 million U.S. service jobs would be sent offshore by 2015; now, many consider that a conservative estimate. To general alarm and political outcry, companies are shipping out more than just manufacturing and IT.
As one finance chief told us last June: “[Offshoring] is only more significant now because white-collar workers are being affected.”
Still, there is no reversing a trend that 42 percent of CFOs say saves them more than 20 percent on average. Before long, finance departments themselves will feel the change. A full 21 percent of CFOs who offshore, or plan to, say they are sending finance and accounting jobs overseas.
Complying with Sarbanes-Oxley
Fox in Sox
Working in haste to appease voters appalled by corporate fraud, lawmakers raced to enact the Sarbanes-Oxley Act of 2002. No law since the Securities Act of 1933 has had such a dramatic impact on Corporate America. CEOs and CFOs are now criminally liable for signing off on misleading Securities and Exchange Commission filings. 10-Qs must be more extensive and completed quicker. The 232-word Section 404 has proved to be the real bear: thousands of man-hours have been logged documenting internal controls, and no company yet knows if it will pass its audit.
The dollar cost is another burden, especially for smaller companies. So it’s no surprise that two-thirds of those surveyed by Foley & Lardner said Sarbox compliance is excessive. Even the SEC must see a problem; it recently began studying how the law is affecting smaller companies.
China, Not Japan
Hu’s on First?
Pop quiz: Which nation produces the lion’s share of the world’s cameras, televisions, and air conditioners?
Twenty years ago, the answer would have been Japan. But a prolonged economic slump has reduced the Rising Sun to a setting star — one quickly being eclipsed by China. Economists predict that China will surpass Japan as the second-largest economy by 2020.
When CFO began, of course, U.S. executives were screaming for protection from Japanese rivals like Sony and Toyota. Now China presents a different dilemma. U.S. companies lust after China’s consumer market and its abundant unskilled workers. What they fear, however, is that businesses in the People’s Republic of China may someday ship top-notch, branded products of their own.
The scenario assumes that China’s renminbi revolution rolls on. Toward that, Beijing would do well to learn from Japan’s experience: protectionist policies, unchecked real estate speculation, and a clannish banking sector can gut any economy.
Paying for Health Care
Say this about health-care insurance costs: they’re consistent — consistently rising, that is. Between 1988 and 2004, employers saw double-digit premium hikes in 9 of those 17 years. How bad is it? When industry watchers spoke of “modest” premium increases last year, they meant a boost of “only” 11 percent.
At first, HMOs offered some relief. But with managed care eventually losing its bite, medical-insurance prices have skyrocketed again. And faced with premium premiums (preferred-provider coverage for a family is now north of $10,000 a year), CFOs have started to dole out some stiff medicine, including scaling back benefits for the expanding legion of retired workers. But most employers haven’t gone as far as the most drastic measure: dumping health-care plans for existing workers.
Scores of companies, however, are asking workers to pay a much greater share of their medical costs. And dozens of large employers have rolled out health savings accounts. Then again, given the jumbo deductibles of these plans, some workers may think HSA actually stands for Hope Sickness Is Averted.
The Magic Penny
Under the reign of CEO Jack Welch, General Electric raised the practice of earnings management to an art form. A notorious 1994 Wall Street Journal article laid out for the world how GE could defy the business cycle and maintain an uncanny record of smoothly rising profits — by offsetting asset sales with restructuring charges, making timely acquisitions and equity sales, changing the return rate on pension assets, and so on.
But GE was merely the most famous example. For most public companies, earnings management became standard operating procedure, and the better they got at it, the more intense the pressure from Wall Street analysts to hit quarterly expectations to the penny.
The trouble was, many companies had to resort to accounting gimmicks to produce the desired numbers. Such gimmicks — taking “big bath” charges, drawing on “cookie jar” reserves, abusing materiality — were the topic of SEC chairman Arthur Levitt’s famous 1998 speech, “The Numbers Game,” in which he warned: “Managing may be giving way to manipulation; integrity may be losing out to illusion.”
With the telecom crash, the gimmicks fell to pieces, leaving major scandals in their wake. Still, as long as investors prize certainty and accounting remains an art, earnings management is likely to continue.
In 1985 the audit business experienced a midlife crisis. Ten years after deregulation, staid CPA firms started moving into sexy ventures like strategic consulting, and accounting firms began to cast themselves as professional-services firms.
To boost profits, the Big Six firms began peddling lucrative nonaudit services. Auditing, once the bedrock of the business, became its loss-leader. CFOs, who historically saw their auditors as numbers cops, began to regard them as partners.
Some auditors, eager to retain big clients, signed off on abusive tax shelters and overlooked GAAP violations. By the late 1990s, every accounting firm had been implicated in at least one restatement. In 2002, to the astonishment of most observers, the massive fraud at Enron devoured Arthur Andersen.
Paradoxically, since then auditors have thrived. CFOs say auditors are more cautious — and costlier than ever, with audit prices doubling this year. With only four big accounting firms remaining, options are scarce for a multinational looking to switch auditors.
Slicing and Dicing
On the page, the 13-letter word looked awkward and even pretentious. But in reality, reengineering was a gritty, in-the-trenches undertaking. Its premises were laid out in a best-selling book by consultants Michael Hammer and James Champy. To stay competitive, they argued, companies needed to abandon their old-fashioned, inefficient ways of producing goods and services, ways based on “Adam Smith’s division of labor.” Nothing less than a radical redesign of the organization would do — one with a ruthless focus on business processes and the customer.
But companies are more complicated than clean slates, and those that undertook to reengineer processes like order fulfillment or procurement faced considerable challenges. Also, reengineering was frequently conflated with the implementation of enterprise software, so an IT mess compounded the HR headache.
The 1990s boom shifted the corporate focus to managing growth, but today companies have once again turned to process efficiency — reengineering — to achieve gains.
The Switch to 401(k)s
The looming Social Security crisis may be great fodder for political debate, but it also illustrates the difficulties of managing worker-retirement funds. You don’t have to tell finance executives — they have been wrestling with pension plans for two decades. In 1974, the Employee Retirement Income Security Act put CFOs in the hot seat as both plan fiduciaries and administrators. The seat got hotter as companies, eager to get out from under pension obligations, switched from pensions to 401(k)s. Today, 401(k) plan assets top $2 trillion while defined-benefit pension plans appear headed for that actuarial table in the sky.
The Price of Free
Talk about irony. In the early 1990s, critics complained that CEOs made too many bucks for the bang. In 1993, Congress limited the tax deduction for the top five executive salaries to $1 million apiece.
About the same time, companies started giving stock options to their executives. They were influenced by academics and shareholder activists who declared that executive pay and performance had to be aligned. And it didn’t hurt that, from an accounting perspective, stock options didn’t cost anything. So strong became the stock-option dogma that Congress almost shut down FASB for suggesting that options weren’t free.
Soon, CEOs were reaping outlandish sums from their options. In fairness, options may have motivated executives to work harder. But as the bull market heated up, it didn’t seem hard to cash them in. And it wasn’t easy to discern how much of the (often short-lived) gain in companies’ stock prices was due to the CEO’s actions, rather than simple investor exuberance.
The collapse of the Internet bubble, and the imminent expensing of options, effectively ended option mania. Now, boards are turning to other forms of pay for top executives. Will they get it right this time?
CFOs as Public Figures
Nobodies to Notoriety
When CFO first started publishing, finance executives labored in obscurity. At the time, most CFOs were charged with managing back-office functions — sexy tasks like bill paying and budgeting. But with accounting software freeing up the finance function, the role of finance chief began to expand. In time, many CEOs came to depend on their CFOs as their second-in-commands. Stepping out from the shadows, finance chiefs like Jerry York and Dennis Dammerman became familiar faces to Wall Street.
In time, some of these partnerships grew cozy. Pushed too hard to make their numbers, some finance chiefs took shortcuts. By the summer of 2002, the sight of a CFO being led through a municipal building in a federally issued orange jumpsuit became a regular image on the nightly news. Suddenly, even average folk joked that “CFO” stood for chief fraud officer, and the names Andrew Fastow and Scott Sullivan soon became punch lines for late-night talk-show hosts.
Lesson? Anonymity is vastly underrated.
The Rise of Investor Activism
In theory, corporate governance is simple. A company’s board oversees big strategic decisions, while management handles daily operations. Stockholders weigh in with proxy votes, corporate resolutions, or calls to their brokers (that is, selling shares).
Unfortunately, this setup has been stretched out of shape in the past 20 years. While corporate officers have paid homage to the notion of maximizing shareholder value, some — like the executives at Enron and Tyco — have run their companies as personal investment vehicles.
In response, shareholders have become more involved in corporate affairs, and some, like TIAA-CREF and Calpers, have turned downright aggressive. Last year, stockholder resolutions reached a record 1,100.
The problem is that shareholder agendas aren’t necessarily in the best interest of all company owners. What’s more, there is scant proof that the reforms advocated improve performance. Not surprisingly, in a 2004 CFO survey, 55 percent of respondents said shareholder activists have gone too far.
The scales might be tipping in CFOs’ favor. The Securities and Exchange Commission’s controversial rule to allow shareholders to nominate board members has bogged down. And stung by condemnation of some of its campaigns, Calpers recently announced the ouster of president Sean Harrigan.
During the 1980s and 1990s, CFOs and research analysts maintained a relationship that bordered on co-dependency. Many CFOs privately shared corporate news with favored analysts. In turn, tipped-off analysts often passed this information on to clients, thus making money for their employers.
Regulation Fair Disclosure poleaxed this arrangement. Put in place by the SEC in October 2000, Reg FD prohibited officers of publicly traded corporations from disseminating material nonpublic information to private parties. Instead, news had to be made available to all investors simultaneously.
For the most part, Reg FD put an end to whisper numbers. In a few cases, it put an end to almost all numbers, as some spooked CFOs stopped talking to analysts (and the press). Then, in 2002, the CFO/analyst relationship took another hit, when New York Attorney General Eliot Spitzer charged that investment banks routinely ordered researchers (think Salomon Smith Barney’s Jack Grubman) to write positive comments about specific companies as a way of winning business. The subsequent $1.4 billion settlement forever changed the CFO/analyst relationship.
It’s the quintessential American success story. In 1962, Sam Walton, working from an Arkansas backwater called Bentonville, launched the first link in what would become the largest retail chain in the world. Like other great entrepreneurs, Walton revolutionized an industry. He located his stores in small towns; he kept overhead low and unions out. Large investments in inventory and communication systems gave Wal-Mart a huge cost advantage. As the company grew, it exercised its muscle on suppliers. The result: rock-bottom prices to customers.
Today, Wal-Mart operates nearly 5,000 stores in 10 countries, and employs some 1.3 million people. Its net sales in fiscal 2004: more than $256 billion.
But not everyone loves this Goliath. Wal-Mart crushes Kmarts and mom-and-pops alike. By itself Wal-Mart is one of China’s largest trading partners, adding to the trade deficit. Labor activists charge that it pays less than a living wage; employees complain about working conditions.
True, the empire that Walton’s heirs inherited is a far cry from his first store. But it wasn’t Sam’s down-home charm that made Wal-Mart great; it was his unswerving focus on the bottom line.
As of last October, the U.S. economy had entered the third year of another bull market, the fourth in 20 years. Typically, say economists, up cycles last only 4.5 years. Research by Standard & Poor’s has found that most turn flat or lower by the 36-month mark. (Except, of course, in the 1990s, when the economy grew almost continuously for 10 years. Most analysts and economists view that as a once-in-a-lifetime occurrence.)
The problem for companies: keeping expectations in line. After all, many analysts and shareholders have witnessed only one down cycle — the collapse of the Internet bubble. The challenge is to convince them that the bubble wasn’t an aberration. Already indicators are suggesting a slowdown — the S&P 500 index, for example, posted a gain of only 9 percent last year, compared with 26 percent in 2003. With issues like a budget deficit that is spiraling toward $500 billion, a widening trade gap, and the continuing war in Iraq, this bull is far from certain to keep charging.
Mergers and Acquisitions
Debt to Equity to Cash
It might surprise Seventh Avenue, but there are fashions in financings, too. In the 1980s, leveraged buyouts were all the rage. In 1988 alone, 388 LBOs were completed, averaging $458 million in value. The purchase of RJR Nabisco for $31.5 billion — $30 billion in the form of debt — made headlines. But soon after the deal closed, RJR almost collapsed under its own weight, and none other than Henry Kravis, the financier who engineered the deal, later admitted: “Debt is out, equity is in.”
Was it ever. In the 1990s, deals in entertainment (Viacom), financial services (Citigroup), and telecommunications (Verizon) were fueled by accelerating stock prices. Some (AOL/Time Warner) destroyed value at a mind-boggling rate. Nonetheless, the average annual worth of deals announced between 1998 and 2000 reached $1.6 trillion — on paper anyhow.
When that paper collapsed, cash became king. Now, on the precipice of another deals bonanza, equity — like the mink stole — is creeping back into style. Procter & Gamble’s $54 billion deal for Gillette, for example, is mostly in stock. LBOs are also back in vogue. Will we soon ask if anyone has learned from past mistakes?
In their simplest forms, derivatives have been around forever. But their use exploded over the past 20 years, thanks in part to floating exchange rates and commodity shocks. Financial engineers became adept at devising ever-more sophisticated instruments to hedge not only interest-rate and currency movements but also exposures like credit risk and even the weather.
Occasionally, the users of these precision tools wounded themselves, sometimes fatally. The roll call of misfortune includes Procter & Gamble, Gibson Greetings, and Barings Bank, bankrupted by Nick Leeson’s rogue trades.
Still, derivatives have become integral to risk management. By June 2004, some $220 trillion of OTC derivatives were outstanding. Is this a good thing? Warren Buffett calls derivatives “time bombs” and warns that the unraveling of contracts could lead to a global financial crisis. But Fed chairman Alan Greenspan praises them and sees no reason to worry.
Nasdaq Versus NYSE
Like It’s 1999
The National Association of Securities Dealers Automated Quotations system opened in 1971, providing a much-needed market for small public companies. It was understood that once a company grew up, it would try to switch to the New York Stock Exchange. But by 1993, Nasdaq’s trading volume surpassed the Big Board’s, thanks to superstars like Microsoft, Intel, and Cisco.
Then, “the stock market for the next 100 years” began to stumble, as an SEC investigation found that market makers colluded to keep spreads wide. Still, on March 10, 2000, the technology-heavy Nasdaq Composite Index reached its all-time high: 5,048.62. Shortly after, the Internet bubble burst and the index began to plummet, losing nearly 80 percent of its value before rebounding somewhat. In early February 2005, the Nasdaq index hovered just above 2,000 — about where it was at the beginning of 1999.
Corporate Tax Rates
In 1985, companies were beginning to prepare for the Tax Reform Act of 1986; now, President Bush is promising a similar overhaul. Still, the corporate approach to taxation couldn’t be more different.
Today, accounting scandals and Sarbanes-Oxley have “radically reworked the relationship of taxes to financial earnings,” says Timothy J. McCormally, executive director of the Tax Executives Institute. And now, he says, there is a “premium on the CFO’s ability to explain variations and fluctuations in the corporate tax rate.” Little wonder, then, as a recent Ernst & Young survey reports, that 44 percent of tax directors say their companies have become more risk-averse in the past two years.
The Pool Is Closed
CFOs strongly opposed FASB’s proposal to eliminate the pooling-of-interests method for merger accounting. Purchase accounting, they argued, would slow the corporate appetite for mergers and cool the red-hot New Economy.
The debate raged through the halls of Congress, but in the end, pooling was scrapped. Surprisingly, its demise failed to unleash a rush of pooling deals before the June 2001 deadline. That was due in no small part to new rules for treating acquired goodwill and intangibles in a purchase acquisition. Obviously, some lessons had been learned from FASB’s last war over stock options.
Profiles by deputy editor Lori Calabro, technology editor John Goff, and articles editor Edward Teach.