In Whose Best Interest?

How accounting firms would change their industry; why performance scorecards still fail; the uninspired American employee; M&A and option backdating; the CFO as investor-relations professional; pension plans with little upside; and more.

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Later this year, the six largest accounting firms plan to hold open forums on their reform proposals for the industry. Those proposals, as outlined in a report called “Global Capital Markets and the Global Economy,” offer half a dozen changes that the firms say will better align the financial reporting and auditing process with today’s business environment. But finance officers and other experts may beg to differ.

“In my opinion, the report is nothing more than a glossy spin job, and not a very effective one at that,” says Bruce Pounder, president of Leveraged Logic and host of a Web-based series, “This Week in Accounting.”

Among the proposals is the idea that companies should issue financial reports more frequently than once per quarter, and disclose a wider range of information. “It’s not realistic,” says Pounder. He and others are concerned about the cost of greater frequency, and point out that competitors, not just investors, would have access to any additional information.

Another idea is to introduce more forensic audits, in which absolutely every transaction, rather than a sample, is reviewed. That’s a nonstarter, says Dana R. Hermanson, professor of accounting at Kennesaw State University. He says sophisticated users of financial reports expect auditors to catch “material financial statement fraud—not all fraud”—which can be done with rigorous audits that focus on high-risk entries, such as end-of-period adjustments. The suggestion that catching fraud requires a review of every single transaction doesn’t hold up, says Hermanson, adding that such audits can be very expensive.

Others maintain that the suggestion that firms undergo forensic audits on a regular basis is, at least in part, an effort to boost auditors’ top lines. “Auditors delight in charging outrageous rates,” such as $1,000-plus an hour for a national Securities and Exchange Commission reviewer from one of the Big Four firms, charges James Wall, retired CFO of Core-Mark. “They’d like the gravy train to keep on rolling.”

Similarly, many observers dispute the report’s suggestion that audit firms should be able to engage in nonaudit services. “Segregation between audit and nonaudit services has been beneficial to the capital markets,” says Pounder.

The report maintains that forensic audits and the other suggestions would go a long way toward redefining the expectations gap, or the difference between what the authors say investors and other users of financial information expect an audit to uncover, and what an audit, as currently completed, actually can determine. In addition, the authors note that several forces are reshaping the world economies—namely easier access to information, growing cross-border trade, and the increasing importance of intangible assets in most companies’ operations—and are changing the type of information that investors and regulators need.

No timetable has yet been set for the forums. Obviously, the accounting firms hope their proposals will be embraced. But they may get a sympathetic audience, at best. Dennis M. Stevens, director of internal audit at Alamo Group, for example, says that “the point of the paper is well founded.” He believes the profession fundamentally needs to reinvent itself and move to a greater understanding of the processes used to determine the numbers being audited. —Karen Kroll

What Auditors Want…

(A) An Internet-based system delivering customized real-time corporate information

(B) Special forensic audits conducted randomly to detect fraud

(C) A single set of globally accepted accounting/auditing standards

Source: “Global Capital Markets and the Global Economy”

Links Still Missing

Scorecard systems that help track performance have been around for years. So why do companies still use them incorrectly?

A new survey sponsored by a group of 10 organizations and associations confirms what might seem intuitive: scorecards are not static instruments. It all comes down to whether or not they are linked to strategy, says Raef Lawson, co-author of the survey and director of research at the Institute of Management Accountants. “Scorecards are meant to track the progress of a company trying to meet a goal. Companies that link their cards to budgeting, compensation, and feedback are more successful,” he says.

The problem is that companies still have trouble making those connections. Using the six key principles outlined in the book The Strategy-Focused Organization—including tying budgeting and incentives to scorecard measures and tracking performance over time—the survey asked 193 companies whether they saw any benefit from their systems. Only 50 percent of respondents said they did.

One barrier is that executives are slow to accept scorecards as a vehicle for managing strategy, rather than another measurement tool, says David Norton, co-author of the aforementioned book, along with Harvard Business School professor Robert Kaplan. “There is no generally accepted structure to describe a strategy like innovation,” he explains. The companies that benefit from scorecards, he adds, develop them with input from the executive team; inform the whole company, including shareholders, about the strategy; and manage the scorecard by making the necessary links.

Brendan Colgan understands the importance of using scorecards to provide feedback for managers. The CFO of Anderson Group uses a scorecard to monitor sales lost to competitors at one subsidiary. “It helps us identify where our competitors stand,” says Colgan. “For example, if we have 60 percent of market share, we should have at least a 60 percent success rate each month.”

Norton predicts that, as they did with quality management, companies will routinely incorporate strategy into their scorecard systems, probably within five years. —Laura DeMars

Comment on This

There was a lot of squawking this fall after European CFOs received comment letters from the Securities and Exchange Commission demanding additional information—sometimes lots of it—about how their International Financial Reporting Standards (IFRS)–based filings translate into U.S. generally accepted accounting principles. AstraZeneca CFO Jon Symonds was among the most vocal, accusing the SEC of setting itself up as “judge and jury” over international companies’ financial statements.

The SEC’s actions, says Mark S. Bergman, an attorney in the London office of Paul, Weiss, Rifkind, Wharton & Garrison, further fueled the perception among some Europeans that the compliance costs of listing on U.S. exchanges are just too high. “If companies feel that compliance costs have gotten out of control, they may well be considering delisting and deregistration,” he says.

Back in the United States, however, regulators suspect a different motive for the complaints. Earlier this year, U.S. and European regulators agreed to use the SEC’s comment letters as part of a process aimed at eliminating the reconciliation of accounting standards altogether. It ought not to have caught anyone by surprise. In November, U.S. Financial Accounting Standards Board chairman Bob Herz went so far as to speculate that European firms that protest too much might be trying to “hide” something.

Former SEC chief accountant Lynn E. Turner, now managing director of research for Glass Lewis & Co., agrees that the outrage may have less to do with principled opposition to the SEC’s extraterritorial reach than with concern that its questions could reveal that companies have not been complying with IFRS. “The real issue is whether companies are really going to comply with either international or U.S. rules and provide a clear picture to investors,” says Turner. “This could indicate that some European companies aren’t complying with either set of accounting and disclosure standards.”

Symonds of AstraZeneca, as well as a representative of the Confederation of British Industry, declined to comment, but the impact of the controversy may become apparent soon. The SEC is finalizing a new rule that will make it much simpler for foreign firms to delist from U.S. stock exchanges. The markets will find out how European companies really feel if they start voting with their feet. —Rob Garver

Are Your Workers Engaged?

Labor statistics indicate that U.S. workers are more productive than ever. What they aren’t is inspired.

According to Sibson Consulting’s 2006 Rewards of Work Study, only 52 percent of employees are fully “engaged,” defined as knowing what to do and wanting to do it. One-third of them are actually disengaged.

Such a disconnect, says Christian M. Ellis, a senior vice president in Sibson’s Los Angeles office, results from “a lack of investment in important people processes.” In the last few years, he explains, many companies have focused on technology and cost containment at the expense of human-capital initiatives. “But value creation is a function of productivity,” he says, “and productivity doesn’t come from cost management.”

Looking for Inspiration?

Engaged employees report higher productivity.

(% productive most of the time)

Engaged: 57% Employees know what to do and want to do it.

Renegades: 11% Know what to do but do not want to do it.

Disengaged: 27% Don’t know what to do and even if they did, wouldn’t do it.

Enthusiasts: 5% Want to do their work, but do not know what to do.

Source: Sibson Consulting

Backdating Nibbles

The drawn-out saga of Hewlett-Packard’s purchase of Mercury Interactive earlier this year seemed certain to dampen merger-and-acquisition activity, as potential buyers pulled back from targets possibly contaminated by backdating. But the deals market has not been obviously affected; 2006 remains on track to surpass every year since 2000 in total M&A volume. (See “The Year of Living Strategically.”)

The prominence of the HP-Mercury deal created the false impression that the backdating scandal would have a chilling effect on mergers. It “led people to believe that there would be a lot of companies in M&A transactions that had been involved in backdating scandals,” says Steven B. Stokdyk, a partner with law firm Latham & Watkins in Los Angeles.

That didn’t happen, says H. Rodgin Cohen, chairman of law firm Sullivan & Cromwell, partly because the problem seems to be limited to companies in particular industries.

In most cases, companies that engaged in backdating did so in a manner that any competent due-diligence effort would uncover, Cohen adds. “Unless the books were cooked, it shouldn’t be hard to find.”

This is not to say that companies shouldn’t worry about backdating in future deals. “Every few years a new issue comes along that boards and management get all worried about,” says Mark L. Sirower, who leads the M&A strategy practice at PricewaterhouseCoopers. “Right now, it’s backdating.”

However, rumored class-action suits against MSystems and its acquirer, SanDisk, could be the first of many such lawsuits generated by the backdating scandal. If backdating turns out to be more widespread than it currently seems, feat of legal costs could put a brake on the M&A gravy train. —R.G.

Face Time

Investors are increasingly demanding corporate information from the horse’s mouth—so much so that 40 percent of CFOs expect to spend more time on investor relations this year.

“Personal contact is a key differentiator,” says Bill Bruno, senior vice president at Greenwich Associates, which recently queried public-company CFOs about their IR practices. As institutional investors continue to bypass Wall Street analysts because of Reg FD, he explains, management teams understand that face-to-face meetings are the best way to communicate “tone and confidence.”

As a result, according to the research (part of Greenwich’s annual U.S. Equity Analysts Research Study), CFOs can expect to increase the time they spend conducting one-on-ones and conference calls. Currently, about 60 percent of public-company CFOs spend the equivalent of 2 to 5 days a month on IR. One in 10 say they work on IR up to 10 days a month.

Paul Gifford, vice president of IR for Goodrich Corp., has found that meeting requests from buy-side analysts, as well as hedge funds, have increased “pretty dramatically.” His solution is to supplement conference presentations with more plant tours, group meetings, and individual meetings with investors willing to come to the company’s Charlotte, N.C., headquarters. “Companies have to get creative in order to meet the demand,” agrees Maureen T. Wolff-Reid, president of Sharon Merrill Associates, an IR firm based in Boston. She has also seen an increase in such things as “investor days” (where groups of investors meet with management) and small dinners in New York with CEOs and CFOs.

Is there a downside to all this face time? “Only if it takes away from a CFO’s other responsibilities,” says Bruno. Ultimately, he adds, “a CFO must decide what will have the greatest impact on shareholder value.” —Lori Calabro

Ready for Risk Aversion?

Thanks to the Pension Protection Act (PPA), retirees may soon have to worry about returns, not underfunding. The new law, coupled with FAS 87’s restrictions on smoothing pension earnings over time, encourages fund managers to be more risk averse and to match the duration of a portfolio’s assets with its liabilities. And this so-called liability-driven strategy may sharply curtail gains in favorable markets.

The PPA requires that fund managers calculate pension liabilities based on current bond rates rather than the expected rate of return from a portfolio. Thus, liabilities will be more sensitive to interest rates, and high expected gains from stocks can no longer help diminish them, since they are no longer part of the calculation. “In the past, there was more of an incentive to invest in equities because they could lower your current cash contributions,” says Mark Ruloff, director of asset allocation at Watson Wyatt Investment Consulting. “Actual returns will reduce contributions, of course, but the gain is no longer guaranteed.”

Even before the ink had dried on the law, which passed in August, companies had started eyeing safer returns. In a survey published in October, Towers Perrin found that about 25 percent of companies would consider weighting portfolios more toward bonds or making more use of derivatives to compensate for the new prominence given to interest rates. As of 2005, only 3 to 6 percent of U.S. corporate pension plans took such steps as matching asset and liability durations through derivatives to buffer their portfolios from rate fluctuations, according to Greenwich Associates.

International Paper has already started down that path. According to Bob Hunkeler, vice president of investments, the company decided to better match the duration of its pension assets and liabilities in 2002 after getting burned by the bear market. With the support of then-CFO and now-CEO John Faraci, IP started by hedging its fixed-income portfolio against interest-rate movements. In 2006, it began hedging its entire portfolio. So far, the company hasn’t changed its underlying asset mix, but has instead used derivatives, such as interest-rate swap overlays. It now has 35 percent of the liability of its portfolio hedged, and the $7.4 billion plan actually made money on the swaps it put in place this year, Hunkeler says.

It remains to be seen how many companies will make similar moves. Those that do are likely to go slowly, says Judy Schub, managing director for the Committee on the Investment of Employee Benefit Assets. “Very few people will go toward a totally liability-driven portfolio, since there’s no upside potential,” she says. “If you were to take it to its logical conclusion, you’d end up with more-expensive pension plans.” —Alix Nyberg Stuart

All the News That’s Fit to Sue

When you dial the New Orleans office of Kahn Gauthier Swick LLC, an automated greeting kicks on: “Thank you for calling Kahn Gauthier Swick, the law firm featured in The New York Times, Wall Street Journal, Washington Post, and other nationally prominent media.”

The greeting seems appropriate given one of the firm’s latest cases—a shareholders’ lawsuit based substantially on press reports. Filed in the Federal District Court for Northern California, the lawsuit claims that the stock price of Pegasus Wireless Corp., a $31 million telecom based in Fremont, Calif., sank from $7.60 to $1.10 a share from August to September of this year following negative reports on the Website Motley Fool and in Barron’s.

“I haven’t seen anything like this,” says Alan Bromberg, an expert on securities lawsuits and a professor at Southern Methodist School of Law in Dallas, “but it doesn’t surprise me.” Press reports, he cautions, are a “much less sturdy platform [for a lawsuit] than statements in reports to shareholders or statements in filings to the Securities and Exchange Commission.”

While the articles did contain some unsavory details about the company—including its officers’ alleged connections to convicted felons and securities fraudsters — these details do not prove that securities laws were violated. Nor does the fact that the firm’s stock tanked, says Jay Ritter, a University of Florida finance professor. “The information in Motley Fool and Barron’s has to be shown to be material information that should have been disclosed,” he adds.

Pegasus did not return calls seeking comment. However, in a press release, the company reiterated that it categorically denied the accusations. As for the lawsuit, KGS partner Lewis S. Kahn maintains that it “isn’t based solely on news accounts. When something comes to light about a fraud, we do as much investigation as we can…to substantiate the allegations.”

At press time, the clock was ticking on the 60-day window for KGS to propose a lead plaintiff—which Kahn was confident would happen. —John P. Mello Jr.

Inflection Point

There is no denying that hedge funds are the black holes of the investment galaxy. With some 9,000 funds pulling in $1.2 trillion in investments while offering almost no transparency, they have raised the ire of CFOs and the eyebrows of regulators.

The Securities and Exchange Commission, which was rebuffed in its efforts to make hedge funds register with the agency last summer, recently made another attempt to rein them in. In December, the SEC proposed shrinking the pool of hedge-fund investors. Under a standard established in 1982, individuals had to show a net worth of only $1 million, including their homes, or an annual income of $200,000 to qualify to invest in a fund. The new proposal would raise that benchmark to $2.5 million in investment assets, excluding primary residences, which could reduce the number of qualified investors by 88 percent.

The SEC was “slapped in the Goldstein case [which ruled against registration] and they don’t like to go down quietly,” says David Lerner, a partner with Morrison Cohen in New York. With this proposed new rule, explains Aaron S. Kase, head of the Securities Service Group at law firm Levenfeld Pearlstein in Chicago, the agency is well within its purview to “preclude hedge funds from accepting investors who haven’t amassed a significant amount of assets.”

Whether the move will actually limit tougher attempts to regulate hedge funds remains to be seen. In the wake of the November elections, many observers believe that hedge funds will get a slight reprieve, given everything else that Congress has on its plate. Moreover, says Richard Goldman, a Boston-based partner with law firm Bingham McCutchen, the “SEC is sending a message to Congress with these new rules that it’s getting its hands around hedge-fund regulation.” —L.C.

Verbatim

“With this new guidance, I will personally approve all future requests for attorney-client communications.”

—U.S. Deputy Attorney General Paul McNulty, announcing changes to the controversial Thompson Memo, which offered guidelines to prosecutors investigating corporate fraud—guidelines that were used to solicit privileged information in return for more-lenient treatment

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