Corporate Governance Quality of Earnings

1. Corporate Governance&Quality of Earnings

2. Importance of Earnings Companies and analysts forecast earnings per share EPS = Net Income / common shares outstanding Share prices rise (fall) when companies exceed (fall short) of analysts’ forecasts.

3. Quality of Earnings How well do earnings reflect reality Firms can manipulate price by artificially increasing or decreasing (manipulating) earnings This is called “Cooking the Books”

4. Big Bath Charges If the firm knows it can’t reach forecast, it knows that the price will fall The firm who tries to write off any expenses that may have to be written off in the future exaggerates the current loss to make future prospects look better. Looking for patterns over several years’ financial statements can often identify the “Big Bath”

5. Cookie Cutter Reserves Build up reserves (e.g. bad debt) during good years that can be reduced as needed to meet forecasts. These reserves are estimates and so can be changed? Firms that are taking a “Big Bath” also often build up these reserve estimates.

6. Revenue Recognition Should only be recorded when sale is made and collection is reasonably certain Some firms try to record sales before goods are shipped to customers Some have even shipped goods to salesmen for possible future delivery to customers but count it as revenue today. Look for build up in receivables relative to sales

7. Corporate Governance Direction and oversight by Board of Directors for the benefit of stakeholders Problems from the recent scandals Some executives will do anything to meet forecasts to benefit their own options, bonuses, etc. GAAP includes a number of estimates which are often manipulated Over-reliance on a single measure, such as EPS can be a disaster

8. Sarbanes-Oxley Act(Sox) 2002 To repair investor confidence, the U.S. Congress passed the Public Company Accounting Reform and Investor Protection Act, usually referred to as Sarbanes-Oxley. The legislation aims to stop abuses and errors in several important areas: Outlaws most loans by corporations to their own directors and executives Creates the Public Company Accounting Oversight Board (PCAOB) to oversee external auditors Requires corporate lawyers to report evidence of financial wrongdoing Prohibits external auditors from providing some non-audit services Requires that audit committees on the board of directors have at least one financial expert and that the majority of board members be independent (not employed by the company in an executive position) Prohibits investment bankers from influencing stock analysts Requires CEOs and CFOs to sign statements attesting to the accuracy of their financial statements Requires companies to document and test their internal financial controls and processes Advantages. Some auditors say Sarbanes-Oxley finally gives them the authority to stand up to executives who might be playing tricks with the numbers. In a few of the recent scandals, top executives claimed not to know what was going on in their own companies. Signing their financial statements under oath should have the intended effect of ensuring close attention to the details. The ban on selling certain kinds of consulting to auditing clients should help with the conflict of interest as well. Disadvantages. The requirement to document and test financial controls has generated perhaps the most widespread discussion. Estimates of the cost of compliance vary widely, from a few hundred thousand dollars to several million, depending on the size of the company and initial state of its financial systems. According to one study, U.S. companies will need to spend a total of $7 billion to get into compliance initially. At the same time, regulators and the AICPA are locking horns over the guidelines to implement Sarbanes-Oxley and other regulatory changes. The accountants say they have the expertise needed to write effective auditing rules; the regulators say the AICPA is more interested in protecting its members from lawsuits than in conducting proper audits. To repair investor confidence, the U.S. Congress passed the Public Company Accounting Reform and Investor Protection Act, usually referred to as Sarbanes-Oxley. The legislation aims to stop abuses and errors in several important areas: Outlaws most loans by corporations to their own directors and executives Creates the Public Company Accounting Oversight Board (PCAOB) to oversee external auditors Requires corporate lawyers to report evidence of financial wrongdoing Prohibits external auditors from providing some non-audit services Requires that audit committees on the board of directors have at least one financial expert and that the majority of board members be independent (not employed by the company in an executive position) Prohibits investment bankers from influencing stock analysts Requires CEOs and CFOs to sign statements attesting to the accuracy of their financial statements Requires companies to document and test their internal financial controls and processes Advantages. Some auditors say Sarbanes-Oxley finally gives them the authority to stand up to executives who might be playing tricks with the numbers. In a few of the recent scandals, top executives claimed not to know what was going on in their own companies. Signing their financial statements under oath should have the intended effect of ensuring close attention to the details. The ban on selling certain kinds of consulting to auditing clients should help with the conflict of interest as well. Disadvantages. The requirement to document and test financial controls has generated perhaps the most widespread discussion. Estimates of the cost of compliance vary widely, from a few hundred thousand dollars to several million, depending on the size of the company and initial state of its financial systems. According to one study, U.S. companies will need to spend a total of $7 billion to get into compliance initially. At the same time, regulators and the AICPA are locking horns over the guidelines to implement Sarbanes-Oxley and other regulatory changes. The accountants say they have the expertise needed to write effective auditing rules; the regulators say the AICPA is more interested in protecting its members from lawsuits than in conducting proper audits.

9. NEW REGULATIONS Senior Management CEO and CFO Personally Responsible Must provide internal anonymous reporting of fraud or deception Board of Directors Audit Committee may not include any company employees The audit committee must hire, compensate and oversee the work of any independent public accounting firm hired

10. NEW REGULATIONS External Auditors MUST be independent – auditors can no longer serve as “consultants” too Report to the BOD Audit Committee and NOT to senior managers Public Company Acctg. Oversight Board New regulatory group – appointed by the SEC and Chairman of the Fed Regulates via RULES the auditors – closer scrutiny

11. Corporate Governance Boards of Directors have MUCH MORE power and responsibility Financial information must be very transparent Senior executive compensation must be tied to increased shareholder value – Boards should regulate that closely Cost of compliance estimated at $7billion per year The goal is to instill a strong ethical climate!

12. Measuring Governance CEO must involve Board in major management or financial decisions Compensation systems reward management based on increasing shareholder value not just EPS If you find a problem you must report it – you’d better be able to report you solved it too!