Friday, April 24, 2009
The 11 reporting tips are listed below with a quote from an investor/analyst for each, explaining what they want from company reporting.
1. Have a backbone
Use your objectives and strategy to underpin your reporting and provide the context for your activities and performance. Strategic statements set in isolation from the rest of your reporting can appear as hollow statements of intent.
'Really good management usually have really good discussions because they know what is important to their company. The poorly managed companies do not have that level of confidence.' Investor
2. The big picture
Put your results in the context of market trends. Provide management’s perspective on the competitive landscape and macro environment to allow the reader to evaluate your strategic choices and actions along with the quality and sustainability of performance.
'I need an analysis of what markets they're in and what drives those markets: what their position is and what drives their business model. But you very rarely find anything like that.' Analyst
3. Who are you kidding?
Provide an honest and open analysis of both the upsides and the challenges the company faces. Explain how any areas of underperformance are being addressed.
'You always read it with a pinch of salt… Even a company that has lost a billion dollars highlights the positives.' Investor
4. Flash in the pan
Consider using bridge charts to help investors understand what is driving revenue and profit growth. Is the growth sustainable, or not?
'You can't tell whether a company’s growth is coming from volume growth versus pricing; whether it is organic versus acquired.' Investor
5. Cash is king
Consider including a detailed disclosure about your operating cash flow strategy and performance, including cash conversion ratios, sensitivity to key factors, repatriation restrictions, and so on.
'Let's clear up the cash flow statement because, at the end of the day, it is our best indicator of what 's real.' Investor
6. Not the kitchen sink
Highlight principal risks, not all risks. How might they derail your strategy? How are they managed? What is the sensitivity of underlying performance to changes in these risks?
'They throw in the kitchen sink. The important things are no more prominent than the things that aren't important.' Analyst
7. Bottom up
Challenge whether the segment analysis makes visible the different dynamics inherent within the business. Consider including a few additional line items such as working capital, operating cash flow and capital employed for each segment.
'The area where there is greatest potential for increased disclosure that would add value is in the segment information.' Investor
8. Bridging the GAAP
Embrace non-GAAP measures but apply certain ground rules: reconcile non-GAAP back to GAAP; provide clear definitions of terms used; and make sure that the reader can quickly identify which are the non-GAAP numbers.
'I like non-GAAP measures: they help me increase my understanding of the underlying performance of the business.' Analyst
9. You owe it to them
Debt information is traditionally scattered throughout the report. Bring it together in one place. Include items not typically recognized in the financial statements, such as operating leases. Provide more granularity in the maturity table and reconcile free cash flow to movements in net debt.
'Companies are quick to provide the information you need when issuing a bond. They are not very good at keeping that relationship going…' Analyst
10. Metrics that pay
Explain clearly how management are incentivised, highlighting the link between strategy, short and long-term performance, and the remuneration package.
'Management action is inextricably linked to the structure of their compensation. Simple and clear communication about the KPIs that govern pay is critical.' Investor
11. Wood for the trees
Key information and messages can get lost in the volume of data and the use of jargon. Take a step back. Are you helping the reader to understand key strategic messages and navigate easily through your report by using clear and consistent headings along with tables and charts?
'It's both a problem with lack of granularity; but also a problem with sometimes providing so much granularity that you can't see the wood for the trees.' Analyst
For a full set of tips with good practice examples illustrating to help you understand how each tip might be implemented in practice.each one, download: Good practice examples - download PDF (10,328kb)
Wednesday, April 22, 2009
The Association however, in a report highlights how company layoffs are "leaving holes" within control systems and firms are not using enough resources to combat these increased risks.
The study shows that 88% of Certified Fraud Examiners (CFEs) expect a slight or significant rise in fraud over the next 12 months while only 22.2% have increased spending in the last year on preventative controls.
The Finance News Line of the Controllers' Leadership Roundtable has done resarch indicating that slow economic times bring increased incidences of fraud and employee misconduct, so it is important to make explicit where there is zero tolerance for bending the rules.
Five indicators in particular are the best predictors of likely misconduct at most large companies: 1) A culture of retaliation and discomfort raises concerns;
2) colleagues willing to compromise values for power and control;
3) direct manager lacks trust in and respect for employees;
4) percentage of variable compensation (an increased percentage increases the likelihood of misconduct, especially for senior executives);
5) employees' commitment to job greater than commitment to company.
The report by the Association of Certified Fraud Examiners
Controllers' Leadership Roundtable
Tuesday, April 21, 2009
Excellent article from the Financial Post
Bank lobbyists and politicians are damaging the credibility of corporate reporting and hurting the interests of investors around the world by pulling back on mark-to-market accounting, one of the world's top international accountants warned.
The comments from Tom Jones, vice-chair of the International Accounting Standards Board (IASB), come after U.S. standard-setters unilaterally decided to dilute the controversial accounting rule earlier this month.
In an interview with the Financial Post, Mr. Jones warned of "a loss of credibility" and said the rationale for watering down so-called fair value accounting is "crazy." He also cited concerns about political interference that could undermine the independence of accounting rule setters.
These fears were echoed by other senior accountants, who urged Canadian authorities to resist pressure from big banks to follow the American lead.
In early April, the U.S. Financial Accounting Standards Board pledged to backtrack on fair value accounting under intense pressure from Wall Street and demands from Congress. U.S. lawmakers had even threatened to take the matter into their own hands rather than leave it to the accountants. The resulting FASB rule changes allow banks to use judgment rather than market prices, to value financial instruments.
Despite the urgings of Bay Street, the oversight council of Canada's standards board opted not to move to align with the U.S. when it met earlier this month, though the organization will weigh the matter again after the international accounting board meets this week.
The Canadian stance has received significant backing from the accountancy profession. Chris Clark, chief executive of PricewaterhouseCoopers Canada, said his firm does not support rushing to imitate the Americans and urged authorities to "balance" the demands of banks with "the needs of the investor".
Nouriel Roubini, the New York University economist nicknamed "Dr. Doom" for his prescient forecast of the global economic downturn, yesterday called the U.S. rule changes "a big mistake" that has allowed Wall Street banks to "fudge" their latest set of quarterly accounts.
The changes circumvent capital rules set by bank regulators and would, if adopted, weaken Canada's banking system, said Wayne Landsman, a professor from the University of North Carolina who will speak on the topic at the Rotman School of Management in Toronto on Thursday.
Proponents of fair value, or mark-to-market, accounting say it is the most accurate and independent way to price assets. But bankers say fair value accounting has exacerbated the current financial crisis by unfairly forcing them to take huge writedowns. They say illiquid markets for certain securities have led to fire sale prices that do not represent appropriate valuations, and they have lobbied to be allowed to value certain troubled securities based on their own estimates.
The idea that banks have been forced to write down assets beyond any rational level is "actually crazy," said IASB's Mr. Jones. The market price for troubled financial instruments has probably not even hit the bottom yet, he added.
Mr. Jones insisted there are better answers to the current problems in the banking sector than tinkering with fair value rules. One possibility would be to change the amount of capital that banks are required to set aside by bank regulators, he said.
Politicians and lobbyists in the U.S. seeking to further weaken fair value are having the effect of pressuring global standard setters to follow FASB's lead, Mr. Jones said. European finance ministers, for instance, have already called standard setters outside the U.S. to "level the playing field" on fair value accounting.
The IASB has reacted by urgently cutting short a consultation period on changes to its rules on financial instruments.
The London-based IASB uses a different rule book to the FASB. In recent years, most countries outside the U.S. have adopted or pledged to adopt the IASB rules. At a meeting in the U.K. this month, G20 leaders called for significant progress towards a single set of global accounting standards. Some observers say a single set of rules would make it easier for investors around the world to make informed decisions.
Mr. Jones said the integration plans have not been derailed by the U.S.'s decision to back away from fair value accounting. Full adoption of IASB standards by the U.S. seems unlikely, but some form of convergence is expected in the long term.
"We are going to try to ensure the difference isn't as great as it seems," he added. Mr. Jones noted that IASB rules on fair value also allow companies to exercise judgment in some cases, like the amended U.S. rules.
Separately, members of a joint committee formed by the two accounting organizations to deal with the financial crisis also complained about political interference in their work.
At a London meeting of the Financial Crisis Advisory Group, that was broadcast on the Internet, senior industry experts expressed concern about the politicization of the process of revising accounting standards.
Harvey Goldschmid, the group's joint chair who is a former commissioner of the Securities and Exchange Commission, and IASB chair Sir David Tweedie, were among those who warned of the dangers of political pressure that could weaken the independence of accounting standard setters.
By Duncan Mavin and Eoin Callan
Monday, April 20, 2009
They recently compiled the results of a discussion group on push down accounting. For those not familiar with this term, when a company completes a share acquisition, they will end up paying more that the acquired company's book value for assets acquired and liabilities assumed.
Companies sometimes “push down” the fair value to the acquired subsidiary. On consolidation, nothing changes. The changes affect internal reporting and segment reporting, where asset values are sometimes used for management accounting purposes in calculating asset and earnings based ratios. The additional depreciation or amortization of hard assets and intangibles would affect the subsidiary's earnings.
On the question of when push down accounting is used, the following was observed from a recent Controller's Roundtable discussion:
- 72% pushed down purchase price allocations (including goodwill, intangibles, and fixed asset fair value changes) to acquired businesses.
- 22% said they generally push down the purchase price allocations in most cases, but this could change depending on whether it's a foreign or domestic acquisition.
Check out the Controllers Roundtable.
Tuesday, April 14, 2009
To set the scene--bankers are apologizing all over the place in public, but behind the scenes they are blaming accounting rules for their problems. There is a fierce lobbying effort going on with bankers and their associations/lobbyists/political backers attacking accounting standard-setters.
The banks moan that accounting rules have forced them to report gigantic losses that are not justified. The banks complain that the rules force them to value some assets at the price a third party would pay (the markets), not the price managers and regulators would like them attain.
Recently the banks’ lobbying has affected accounting standard setting in both the U.S. and internationally. How much impact does this have on the capital markets? Independence of accounting standard-setting is essential to the proper functioning of capital markets. It is being compromised.
In April, Congress beat up the chair of the U.S. Financial Accounting Standards Board (FASB), with the result that they rushed through rule changes giving banks more freedom to use models to value illiquid assets and more flexibility in recognizing losses on long-term assets in their income statements.
European ministers moved in lock step with the U.S. and demanded that the International Accounting Standards Board (IASB) make identical changes. Shortly thereafter, they announced word-for-word changes as in the U.S.
Quotes from the article:
“It was banks that were on the wrong planet, with accounts that vastly overvalued assets. Today they argue that market prices overstate losses, because they largely reflect the temporary illiquidity of markets, not the likely extent of bad debts. The truth will not be known for years. But banks’ shares trade below their book value, suggesting that investors are skeptical. And dead markets partly reflect the paralysis of banks which will not sell assets for fear of booking losses, yet are reluctant to buy all those supposed bargains.”
“To get the system working again, losses must be recognized and dealt with. Japan’s procrastination prolonged its crisis. America’s new plan to buy up toxic assets will not work unless banks mark assets to levels which buyers find attractive. Successful markets require independent and even combative standard-setters. The FASB and IASB have been exactly that, cleaning up rules on stock options and pensions, for example, against hostility from special interests. But by appeasing critics now they are inviting pressure to make more concessions. “
“Standard-setters should defuse the argument by making clear that their job is not to regulate banks but to force them to reveal information. The banks, their capital-adequacy regulators and politicians seem to dream of a single, grown-up version of the truth, which enhances financial stability. Investors and accountants, however, think all valuations are subjective, doubt managers’ motives and judge that market prices are the least-bad option. They are right. A bank’s solvency is a matter of judgment for its regulators and for investors, not whatever a piece of paper signed by its auditors says it is. Accounts can inform that decision, but not make it.”
“Banks’ regulators have to take responsibility. If they want to remove the mechanical link between drops in market prices and capital shortfalls at banks, they should take the accounts that standard-setters create for investors and adjust them when they calculate capital. They already do this to some degree. But the banks’ campaign to change the rules is making inevitable a split between two sets of accounts, one for regulators and another for investors. The FASB and IASB can help regulators to create whatever balance-sheet they want. But in doing so they must not compromise their duty to investors.”
Monday, April 13, 2009
They argue that the IASB needs a comprehensive review of the financial instrument accounting rules and not follow a piecemeal agenda to reform accounting standards.
A CFA managing director warns that the amendments to IAS 39 reclassification rules, and the political pressures that have led to the revision of FASB rules on fair value and impairments, are likely to result in "unintended consequences."
"It is essential the IASB avoids engaging in an exercise to dilute standards to align with U.S. GAAP," he says. "This crisis presents a window of opportunity for the IASB to improve the current financial instrument accounting in the interests of all its stakeholders. This can be judged a success if it improves the overall transparency of information available to investors, and if the IASB is able to operate independently to pursue this objective. The short-term focus should be on providing capital relief by amending capital adequacy rules and not by simply changing measurement rules."
The CFA Institute claims that investor interests must come first, and this can only be achieved through improved and transparent financial reporting. They say the new rules could obscure true economic performance and accordingly reduce investor confidence and reduce the ability of constrain the ability of banks to raise private capital, as a result increase risk in world financial systems.
The AICPA said it supports IFRS for public companies but before adoption of it wants the SEC to implement the recommendations of the SEC’s Advisory Committee on Improvements to Financial Reporting relating to the use of professional judgment.
The AICPA notes that only after a final adoption date is set for IFRS will the U.S. financial reporting system make significant changes and move toward adoption. They note that the requirement of the SEC for three years of comparative information is a barrier to adoption. More specifically, if the final adoption date is 2014, U.S. issuers must begin to adopt IFRS in 2011, in order to have comparative figures available. They argue that companies would need up to two years to make necessary upgrades, suggesting that the transition will take five years—two years of upgrades plus three years to compile comparative figures.
The AICPA suggests that implementation could be shorter SEC allows U.S. issuers to follow IFRS 1, First-time Adoption of International Financial Reporting Standards, and provide only two years of information in the year of adoption, i.e. the current year plus one year of comparatives.
The AICPA feels that the SEC Roadmap requires dual recordkeeping—in the years prior to adoption, companies need to keep two years of recorded in both U.S. GAAP and IFRS.
The AICPA supports limited early adoption of IFRS, but argues that more companies, including smaller issuers, should be allowed to early-adopt.
The AICPA also recommends that the SEC set aside a portion of its current public company levies to fund standard-setting activities of the International Accounting Standards Board.
The AICPA’s Board of Examiners has issued new IFRS material for the CPA exam that include IFRS that will be on the Uniform CPA Examination on or before 2012.
Thursday, April 9, 2009
In a speech in Washington, Blankfein took a shot at critics of fair value accounting and those who claim that mark to market accounting caused or made worse the current financial crisis.
Blankfein stated: “If more institutions had correctly valued their positions and commitments at the onset, they would have been in a much better position to reduce their exposure,”
“To increase overall transparency and help ensure that book value really means book value, regulators should require that all assets across financial institutions be similarly valued. Fair value accounting gives investors more clarity with respect to balance sheet risk. How can one justify that the same instruments or risks are priced differently because they reside in different parts of the balance sheet within the same institution?”
The full text of his speech is a good read and is reproduced below.
Good morning. I appreciate the opportunity to speak with you today. For more than two decades, the Council of Institutional Investors has committed itself to the values of accountability, transparency, and responsible ownership. I'm pleased to be able to speak to those principles in front of a group that has played such a powerful role in advancing them over the years.
To begin with an obvious point, much of the past year has been deeply humbling for my industry. We held ourselves up as the experts, and the loss of public confidence from failing to live up to the expectations that we created will take years to rebuild. Worse, decisions on compensation and other actions taken and not taken, particularly at banks that rapidly lost a lot of shareholder value, look self-serving and greedy in hindsight.
Financial institutions have an obligation to the broader financial system. We depend on a healthy, well functioning system, but we collectively neglected to raise enough questions about whether some of the trends and practices that became commonplace really served the public's long-term interests.
Meaningful change and effective reform are vital and should naturally emanate from the lessons learned. I will discuss a few of the more important lessons from this crisis. I'd also like to highlight some of the regulatory guideposts that may help us to improve the broader systemic management of risk, increase the level of institutional accountability, and enhance investor confidence.
Without trying to shed one bit of our industry's accountability, we would also further our collective interests by recognizing other contributing causes to the severity of the cycle we are living through.
As a matter of policy, we allowed housing prices to be subsidized, including through implied government support of Fannie Mae and Freddie Mac. We watched as high consumption and low savings rates as well as entitlement spending were increasingly encouraged and financed through the twin deficits.
Factors from both Main Street and Wall Street contributed to today's circumstances. Neither part of our economy acted completely independent of the other. So, any examination of how we got to this point must begin with an understanding of some of the global economic and financial dynamics of the last two decades.
Certainly, what started in a localized part of the U.S. mortgage market spread to virtually every corner of the global financial markets. But the genesis of the problem wasn't in sub-prime. Instead, the roots of the damage to our financial system are broad and deep. They coalesced over many years to create a sustained period of cheap credit and excess liquidity. The resulting underpricing of risk led to massive leverage across wide swaths of the economy -- from households to the corporate sector to the public sector.
I see at least three broad underlying factors:
First, there has been enormous growth in the amount of foreign capital, much of it held in large pools, and a very significant shift in the balance of payments of many emerging markets;
Second, and linked to this, nearly ten years of low long-term interest rates; and
Third, the official policy of subsidizing homeownership in the United States.
Let's take each in turn, beginning with the growth in foreign capital.
Between 1992-2007, the U.S. current account deficit increased by more than 1,300 percent. During the same period, China's current account surplus increased by over 5,700 percent, as did the surplus for the oil exporting nations.
After previous financial crises, emerging economies began to self-insure against a repeat of those events by building up their foreign currency reserves. Their primary objective was to reduce their dependence on dollar-denominated domestic debt.
Of course, the other, perhaps more significant factor in the growth in current account surpluses had been the record run-up in oil prices since 2000. Increases in global savings run almost parallel with the increase in petrodollar flows.
The growth in foreign capital had a profound effect on the global economy. Foreign holdings of U.S. government and corporate debt skyrocketed. China's monthly average purchases of U.S. long-term securities went from less than $2 billion in 2001 to over $15 billion in 2007.
The flood of foreign capital into safe and liquid assets, particularly U.S. Treasurys, helped push relatively low long-term interest rates down even further. And they stayed low, even after the Federal Reserve began raising short-term rates in 2004.
This was accompanied by a significant reduction in inflation. Between the period 1985 and 1995 versus the next 12 years, inflation in advanced economies fell by more than one-half.
Enormous excess liquidity, strong global economic growth, and low real-interest rates created a desire to find new investment opportunities. Many of the best were thought to be in the housing market. The reasons are threefold.
First, governments, particularly the U.S., explicitly supported homeownership through a variety of government programs and initiatives. Second, mortgage assets were considered relatively impervious to sharp downturns. And lastly, the creation of more flexible and varied mortgage products attracted even more capital in search of higher returns.
These factors, to varying degrees, contributed to a housing bubble -- not just in the U.S. but in many other countries as well. While real home prices increased nearly 50 percent in the U.S. between 1998 and 2006, they increased more than 130 percent in Ireland, 120 percent in the U.K. and Spain and over 100 percent in France.
Not surprisingly, in the U.S., mortgage origination as a percentage of total mortgage debt outstanding rose from an average of 6.3 percent between 1985 and 2000 to 10 percent between 2001 and 2006. Subprime debt, in particular, grew from just over 2 percent in 2002 to 14 percent in 2008. In a sustained environment of cheap capital, lending standards for residential mortgages simply deteriorated.
As I have thought about our industry's understanding of the previous years' risks, it is important to reflect on some of the lessons.
At the top of my list are the rationalizations that were made to justify that the downward pricing of risk was different. While we recognized that credit standards were historically lax, we rationalized the reasons with arguments such as: The emerging markets were more powerful, the risk mitigants were better, there was more than enough liquidity in the system.
We rationalized because our self-interest in preserving and growing our market share, as competitors, sometimes blinds us -- especially when exuberance is at its peak.
A systemic lack of skepticism was equally true with respect to credit ratings. Too many financial institutions and investors simply outsourced their risk management. Rather than undertake their own analysis, they relied on the rating agencies to do the essential work of risk analysis for them. This was true at the inception and over the period of the investment, during which time they did not heed other indicators of financial deterioration.
This overdependence on credit ratings coincided with the dilution of the coveted triple A rating. In January 2008, there were 12 AAA-rated companies in the world. At the same time, there were 64,000 structured finance instruments, like CDO tranches, rated AAA. It is easy to blame the rating agencies for their credit judgments. But the blame is not theirs alone. Every financial institution that participated in the process has to accept part of the responsibility.
More generally, risk management will come to define the events of 2007 and 2008. First, models, particularly those predicated on historical data, were too often allowed to substitute for judgment.
In the last several months, we have heard the phrase, "multiple standard deviation events" more than a few times. If events which were calculated to occur once in twenty years in fact occurred much more regularly, it doesn't take a mathematician to figure out that risk management assumptions did not reflect the distribution of actual outcomes. Our industry must do more to enhance and improve scenario analysis and stress testing.
Second, size matters. For example, whether you owned $5 billion or $50 billion of (supposedly) no-risk super-senior debt in a CDO, the likelihood of losses would appear to be the same. But the consequences of a miscalculation were obviously much bigger if you had a $50 billion exposure.
Third, a lot of risk models incorrectly assumed that positions could be fully hedged. After LTCM and the crisis in emerging markets in 1998, new products like basket indices and credit default swaps were created to help offset a number of risks. However, we didn't, as an industry, consider carefully enough the possibility that liquidity would dry up, making it difficult to apply effective hedges.
Fourth, risk models failed to capture the risk inherent in off-balance sheet activities, such as Structured Investment Vehicles. It seems clear now that managers of companies with large off-balance sheet exposure didn't appreciate the full magnitude of the economic risks they were exposed to; equally worrying, their counterparties were unaware of the full extent of these vehicles and, therefore, could not accurately assess the risk of doing business. Post Enron, that is quite amazing.
Fifth, complexity got the better of us. The industry let the growth in new instruments outstrip the operational capacity to manage them. As a result, operational risk increased dramatically and this had a direct effect on the overall stability of the financial system.
Lastly, financial institutions didn't account for asset values accurately enough. I've heard some argue that fair value accounting -- which assigns current values to financial assets and liabilities -- is one of the major reasons for exacerbating the credit crisis. I see it differently. If more institutions had properly valued their positions and commitments at the outset, they would have been in a much better position to reduce their exposures.
For Goldman Sachs, the daily marking of positions to current market prices was a key contributor to our decision to reduce risk relatively early in markets and in positions that were deteriorating. This process can be difficult, and sometimes painful, but I believe it is a discipline that should define financial institutions. We mark-to-market, not because we are required to, but because we wouldn't know how to assess or manage risk if market prices were not reflected on our books.
While this is not an exhaustive list of what went wrong, our focus is on learning from these lessons and others that will undoubtedly emerge as we work our way through this period.
The administration, legislators, and regulators have begun to consider the important regulatory actions to be taken and our firm pledges to be a constructive participant in that process. In that vein, I believe it is useful, in light of the lessons we take away from this crisis, to consider important principles for our industry, for policy makers and for regulators.
For the industry, we can't let our ability to innovate exceed our capacity to manage. Given the size and interconnected character of markets, the growth in volumes, the global nature of trades and their crossasset characteristics, managing operational risk will only become more important.
Risk and control functions need to be completely independent from the business units. And clarity as to whom risk and control managers report is crucial to maintaining that independence. Equally important, risk managers need to have at least equal stature with their counterparts in revenue producing divisions.
If there is a question about a mark or a disagreement about a risk limit, the risk manager's view should prevail.
Understandably, compensation continues to generate a lot of controversy and anger. We recognize that having TARP money creates an important context for compensation. That is why, in part, our executive management team elected not to receive a bonus in 2008, even though the firm produced a substantial profit. Beyond TARP, public scrutiny, a renewal of common sense and, perhaps, regulation will naturally affect compensation practices going forward.
More generally, we should apply basic standards to how we compensate people in our industry. Compensation should reflect an individual's ability to identify and create value, including his or her contribution to the client franchise, enhancing the firm's reputation and contributing to the better functioning and efficiency of markets.
Equally important, compensation should take into account strict adherence to a firm's management and controls, especially with respect to a person's judgment and exercising that judgment in terms of risk in all of its forms. That evaluation must be made on a multi-year basis to get a fuller picture of the effect of an individual's decisions.
And, individual performance must not be viewed in isolation. Individual compensation should not be set without taking into strong consideration the performance of the business unit and the overall firm. Employees should share in the upside when overall performance is strong and they should all share in the downside when overall performance is weak.
No one should get compensated with reference to only his or her own P&L. Compensation should encourage real teamwork and discourage selfish behavior, including excessive risk taking, which hurts the longer-term interests of the firm and its shareholders.
We also believe it is important to set forth specific guidelines on how we compensate in our industry.
Compensation should include an annual salary plus deferred compensation, which is appropriately discretionary because it is based on performance over the entire year.
The percentage of compensation awarded in equity should increase significantly as an employee's total compensation increases.
For senior people, most of the compensation should be in deferred equity. Only the firm's junior people should receive the majority of their compensation in cash.
As I mentioned earlier, an individual's performance should be evaluated over time so as to avoid excessive risk taking and allow for a "clawback" effect. To ensure this, all equity awards should be subject to future delivery and/or deferred exercise over at least a three-year period.
And, senior executive officers should be required to retain the bulk of the equity they receive until they retire. In addition, equity delivery schedules should continue to apply after the individual has left the firm.
At Goldman Sachs we believe attracting and retaining the best people is vital to our effectiveness and that incentives are an important element in that process. But we also recognize that, misapplied, they can also encourage excess. As an industry, we need to do a better job of understanding when incentives begin to work against the social good rather than for it and take action to redress the balance.
For policymakers and regulators, it should be clear that self-regulation has its limits. At the very least, fixing a system-wide problem, elevating standards or driving the industry to a collective response requires effective central regulation and the convening power of regulators.
While all of us in the industry have a common responsibility to ensure the system's operational integrity, it is not realistic to expect that one firm alone can fix a system-wide problem like unsigned trade confirmations or the establishment of a central clearing facility.
Capital, credit and underwriting standards should be subject to more "dynamic regulation." Regulators should consider the regulatory inputs and outputs needed to ensure a regime that is nimble and strong enough to identify and appropriately constrain market excesses, particularly in a sustained period of economic growth. Just as the Federal Reserve adjusts interest rates upward to curb economic frenzy, various benchmarks and ratios could be appropriately calibrated.
To increase overall transparency and help ensure that book value really means book value, regulators should require that all assets across financial institutions be similarly valued. Fair value accounting gives investors more clarity with respect to balance sheet risk. How can one justify that the same instruments or risks are priced differently because they reside in different parts of the balance sheet within the same institution?
As recognized at the recent G20 summit, the level of global supervisory coordination and communication should reflect the global interconnectedness of markets. Regulators should implement more robust information sharing and harmonized disclosure, coupled with a more systemic, effective reporting regime for institutions and major market participants. Without these, regulators will lack essential tools to help them understand levels of systemic vulnerability in the banking sector and in financial markets more broadly.
In this vein, all pools of capital that depend on the smooth functioning of the financial system, and are large enough to be a burden on it in a crisis, should be subject to some degree of regulation. Yes, that includes large hedge funds and private equity funds.
After the financial shocks and unsettling developments of recent months, I understand the desire for wholesale reform of our regulatory regime. And, in many cases, it is warranted. But we also should resist a response that is solely designed to protect us against the 100-year storm.
As long as human emotions influence decisions, this won't be the last financial crisis the world has to contend with. But, most of the last century has been defined by markets that fund innovation, reward entrepreneurial risk taking and act as an important catalyst for economic growth.
History has proven that a vibrant, dynamic financial system is at the heart of a vibrant, dynamic economy. The U.S. brand of that system has produced growth nearly one-third higher than the rest of the industrialized world over the last two decades.
The events of the last year have put into stark relief the tension between innovation and stability. But, if we abandon, as opposed to regulate, market mechanisms created decades ago, like securitization and credit default swaps, we may end up constraining access to capital and the efficient hedging and distribution of risk, when we ultimately do come through this crisis.
Certain developments of recent decades, like changes in the structure of financial institutions post Glass-Steagall, have brought the risk of less frequent but more intense upheavals. The diverse income streams of mega financial conglomerates reduce the effects of the 10-year storm, but their size and ubiquity exacerbate the consequences of the 20- or 30-year storm.
Over the last several months, there have also been a number of broader policy lessons. Many had previously accepted the bifurcation of Wall Street and Main Street as well as the decoupling of the United States from the international economy. Both have proven false. In 2007, there were pitched debates over whether policy was being geared towards Wall Street at the expense of Main Street. Today, Wall Street remains destabilized, impeding the broader economy.
In terms of international implications, we have also seen actions that, for all intents and purposes, are protectionist and self-defeating. For instance, recent legislation constrains the ability of financial institutions to hire employees through the H-1B visa program. This program helps bring the most highly trained and technical people into our labor market.
The U.S. has always been a magnet for many of the most talented, hungry and qualified people in the world. Especially at this time in our economy, do we really want to tell individuals who will help companies to grow and innovate -- ultimately creating more jobs -- that they should go work elsewhere?
Equally significant and using Goldman Sachs as an example, we have approximately 200 employees who are in the U.S. because of the H-1B program. But, we have 2,000 employees who are working overseas and pay U.S. taxes. Do we want to invite other countries to take punitive measures against us?
This may be a relatively minor issue in the midst of the significant challenges we face, but I think it speaks to a potentially dangerous trend of withdrawing at a time we should do the opposite. While I don't dismiss political considerations, short-term salves like the "Buy America" provision or mandating a certain level of domestic lending will only end up harming the process underlying economic growth.
All along, we have known that market events and economic trends are interwoven on a global basis. But the events of the last year have shown that the connections are more direct and immediate than perhaps we previously appreciated.
In times of economic distress, the relationships between creditor and debtor countries take on even more complex dynamics ... especially as we are the largest debtor. We have learned that when a major financial institution fails in a debtor country, a creditor country is likely to pull back from its financing relationship in one way or another and, maybe, in every way.
For the United States at this time, the relationship is not just a matter of here and abroad; it is also a relationship between a debtor and its creditors. Certain of our economic decisions that have implications for our international partners could reverberate back to us very quickly and with great consequences in the current environment.
I want to conclude today with the following thought: We are fighting for nothing less than the immediate health and security of every person. We can never forget the products of economic growth -- more accessible health care, better education, less crime, tolerance of diversity, social mobility and a commitment to democracy.
In so many respects, change is the order of the day. We have much to do to repair our financial system and reinvigorate our regulatory structure. At the same time, our financial system, rooted in the belief of putting risk capital to work on behalf of ideas and innovation, has helped produce a long-term record of economic growth and stability that is unparalleled in history.
We have to safeguard the value of risk capital, which is at the heart of market capitalism, while enhancing investor confidence through meaningful transparency, effective oversight and strong governance. But, there should be no doubt: Markets simply cannot thrive without confidence.
Though honest disagreements will occur, the best companies don't shy away or selfishly frustrate efforts to compel better industry practices. These companies recognize that they are the first to benefit from better standards, especially if their business requires extensive dealings with partners or counterparties. But, we have to recognize a higher responsibility: to speak up, to draw attention to potentially destabilizing trends and to act like an owner responsible for the integrity of the system.
I, for one, know we have not done the best job in the recent past but working with you, as many of the world's most important investors, Goldman Sachs pledges to recommit itself to this fundamental obligation.
Thank you very much.
S&P said that its ratings of banks won’t change, in spite of the rule changes. U.S. banks lobbied heavily in favour of the new rules.
Related comments by S&P:
- "In our view, the revised fair-value measurement standard provides more flexibility in how banks and other financial institutions will value financial assets,"
- "when market observations are substantially lacking or are meaningfully influenced by temporary supply-and-demand imbalances or market disruptions." This "should be accompanied by relevant financial statement disclosures."
- the key indicator to watch in the upcoming round of quarterly filings from large complex banks will be expansions in the valuation of level 3, or illiquid assets
- They are in favor of the increased transparency of credit losses the “other than temporary impairment losses” rules bring, but that they could result in “reliability issues related to a company’s ability to bifurcate losses into credit and noncredit components because the credit impairment amounts may be difficult to decipher in isolation.”
- Fair value measurement changes will result in increased analysis in evaluating significant adjustments companies make to observable market prices and related assumptions and judgements they apply.
- “This shift [to assets being valued using level 3] ... is a move toward greater use of internally derived measures," Determination of whether a market is active or not will be based on "the highly subjective judgement of each company."
Wednesday, April 8, 2009
HONG KONG -- Ping An Insurance (Group) Co. of China Ltd. an impairment charge of 22.79 billion yuan (US$3.33 billion) on the company's stake in Fortis NV.
First Data Corp. reported goodwill impairment charge of $3.2 billion which resulted from the decline in economic conditions which drove a change in First Data's management projections and an increase in discount rates reflected in First Data's fair value estimates.
MGM MIRAGE reported goodwill and indefinite-lived intangible asset impairment charges of $1.2 billion as a result of global economic conditions and market trends--and that these trends have continued into the first quarter of 2009.
Rite Aid goodwill impairment, store impairment and deferred tax asset write-down that totaled $2.2 billion. The goodwill impairment charge is related to the July 2007 Brooks Eckerd acquisition.
Oshkosh Corporation anticipates recording non-cash impairment charges of $1.2 - $1.5 billion for the write-down of goodwill and other indefinite-lived intangible assets in the second quarter of driven by the short-term economic environment.
Tuesday, April 7, 2009
The "plain language" version of the changes.
The FASB considered three proposals yesterday. Two of the proposals were related to fair value (mark-to-market) accounting, and one was associated with accounting for impaired securities, such as mortgage-backed securities.
The first proposal (on FAS 157) relates to how to figure out fair values when there is no active market or where the price inputs being used really represent distressed sales. After considering all of the feedback we received on our original proposal issued two weeks ago, the FASB yesterday reaffirmed that the objective of measuring fair value has always been and continues to be the same since FAS 157 was published. The objective is to reflect how much an asset would be sold for in an orderly transaction (as opposed to a distressed or forced transaction) at the date of the financial statements. Specifically, yesterday's vote said that companies should look at factors and use judgment to ascertain if a formerly active market has become inactive.
Once a company has made that determination, more work will be required to estimate the fair value. In trying to estimate fair value in an inactive market, the company must see if the observed prices or broker quotes obtained represent "distressed transactions". Other techniques such as a management estimate of the expected cash flows might also be appropriate in that circumstance. However, even if a company analysis is used, it must meet the objective of estimating the orderly selling price of the asset under current market conditions. Some financial institutions have made public statements that they do not expect this proposal to significantly impact their financial statements.
The second proposal relates to fair value disclosures for any financial instruments that are not currently reflected on the balance sheet of companies at fair value. The current rule is that fair values for these assets and liabilities are only disclosed once a year. The board voted yesterday that these disclosures should be required on a quarterly basis, providing qualitative and quantitative information about fair value estimates for all those financial instruments not measured on the balance sheet at fair value. For commercial banks, one financial asset impacted by this is loans, which will now have disclosures about their fair value every quarter.
The third proposal deals with other-than-temporary impairment (OTTI). The proposal would not change when a company recognizes impairment. It could change where in the financial statements the impairment is reported. Under the current rules, unless the severity and duration of a drop in fair value is too great, if a company can assert that it intends and is able to hold a security until the fair value recovers, it need not record an impairment charge on the income statement. The new proposal the board approved indicates that no impairment charge is required if there is both no current intention to sell and, it is more likely than not, that it will be required to sell prior to the fair value recovering.*
However, if management expects at the financial statement date that all of the cash flows won't be 100% collected, an impairment must be recorded in the statement of income.
In certain situations, the proposal changes the presentation of the impairment charge, splitting it up into two pieces. First, the amount of the impairment related to just the credit losses will be reflected on the income statement and will reduce net income. Second, the amount of the impairment related to all other factors will be shown in other comprehensive income in the equity section of the balance sheet. There will be a "gross" presentation of this on the income statement, one which will clearly display the total reduction in fair value below cost, the amount offsetting it that is being charged to other comprehensive income, and the net amount that is being recorded through net income.
Many balance sheet metrics used to analyze banks, such as tangible common equity, should be relatively unaffected by this proposal, though earnings, other comprehensive income and retained earnings would be impacted. The board did add significant new disclosures as part of this proposal as well.
Generally, these new proposals will be effective for the second quarter, though companies may elect to adopt them for the first quarter. However, we indicated that if a company wants to adopt the impairment proposal in the first quarter, it must also adopt the FAS 157 fair value in inactive markets proposal.
These proposals should be considered in the context of the larger ongoing joint project with the International Accounting Standards Board (IASB) to reconsider accounting for financial instruments. A proposal on this project is expected to be issued later this year.
*This sentence may be true for a HTM security but it is not true for an AFS security. For an AFS security an impairment charge is required anytime the security’s fair value is below cost since the measurement attribute for AFS securities is fair value – it just maybe that the charge would go into OCI--instead of earnings if it is determined to be not other than temporary.
Monday, April 6, 2009
Deloitte published the results of a survey on the SEC's proposed IFRS roadmap, which was last November. The comment period for the roadmap ends on April 20, 2009 .
The point of the survey was to gather data and information about how companies perceive the SEC's proposed IFRS roadmap. and how companies are approaching IFRS, given current economic and regulatory uncertainty.
The survey was conducted in March 2009 on over 150 finance professionals.
- 75% supported or strongly supported a movement toward a single set of high quality accounting standards, such as IFRS.
- 62% agreed or strongly agreed that the SEC should establish a date (the so-called "date certain") for requiring U.S. companies to use IFRS.
- 56% of respondents surveyed indicated t hat the SEC should extend the option for early use of IFRS to a broader group of U.S. companies than outlined in t he current SEC roadmap. (Proposed to be limited to those among the top 10 in their industry globally as measured by market capitalization and operate in an industry where IFRS is the predominant accounting standard used among the top 10 largest listed companies worldwide in their industry.)
- 61% responded that the SEC' proposed requirement that would entail having companies maintain U.S. GAAP books on an ongoing basis until 2011, would decrease the likelihood of companies electing the option of early conversion.
- 56% of financial executives described the proposed SEC timeline to be "about right" or could be accelerated further.
- 64% of respondents stated that no budget has yet been allocated for IFRS conversion, in contrast to 25% who have budgeted for assessment and readiness, or all aspects of conversion.
- 54% of responden ts indicated some or sufficient in-house knowledge of IFRS, while 40% acknowledged no IFRS in-house knowledge or experience.
The group athey also called for a Financial Stability Board to have authority to review and advise financial regulators and standard-setting bodies.
Their wish list includes:
- Progress towards a single set of high-quality global accounting standards;
- Reduction in complexity of accounting standards for financial instruments;
- Clarity and consistency in the application of valuation standards internationally;
- Independent standard-setters;
- Improved accounting standards for provisioning, off-balance-sheet exposures and valuation uncertainty;
- Improves involvement of stakeholders, including regulators and emerging markets, through the IASB’s constitutional review.
Commenting on the most recent changes to mark-to market accounting rules by the FASB, Norris states in his blog:
“the change came after a subcommittee of the House Financial Services Committee made clear that FASB could be destroyed if it did not knuckle under to the banking lobby.
“Arthur Levitt and Bill Donaldson, two former chairmen of the Securities and Exchange Commission, bemoaned the politicization of the board, but the current chairman of the commission, Mary Schapiro, does not appear to have resisted the political pressure. That is understandable, but not necessarily admirable.”
Barney Frank, the chairman of the U.S. Congress Financial Services Committee stated after the changes were fast-tracked through the FASB rule-changing process that : “The integrity of the standard-setting process is preserved, while avoiding the pro-cyclical effects of improper valuation practices.”
Norris questions “Just how was the “integrity of the standard-setting process” preserved by using political pressure to force the board to do something it did not want to do? And how does Mr. Frank know that markets are now producing “inaccurate asset valuations,” but that the banks that created and bought these assets know what they are really worth?
“If the disclosures the FASB will now require really provide useful information, this could be a pyrrhic victory for the banks, much as the win on stock option accounting might have been.”
“Then, as now, those putting pressure on the banks wanted to keep reported profits from being changed by something they deemed unreasonable. But the FASB, in backing down, forced disclosure of what the impact would have been if options were expensed. The information that accumulated helped make it possible for the board to eventually impose the rule it had wanted to pass in the first place.”
“Could it be that these disclosures will work in the same way, by making it clear to those who read the footnotes just how much profits are being pumped up by the banks assuming that they know the real values of assets, even though nobody will pay that price for them right now?”
“In the long run, such disclosures might make it possible for us to track just how right (or wrong) the banks were in their confidence that they knew better than the market.”
“Or maybe my innate optimism is showing, and the new disclosures will not provide much useful information at all.”
The last six months have been controversial for both U.S. GAAP and IFRS. Political pressures have been brought against both the U.S. standards and IFRS as a result of controversy over fair value/mark to market accounting.
The specter of political issues haunting accounting essentially could pit the SEC and the FASB against with the International Accounting Standards Board (IASB). In announcing the roadmap a few months back, the SEC called for improvements to funding and governance of the IASB. In more recent statements, the SEC has criticized IFRS as inadequate.
Recently MIT and Wharton professors argued in a paper that there are reasons to slow down the change to IFRS.
The authors theorize that unique aspects of the U.S. economy and capital markets will not be well served by IFRS “the [IFRS] standard setting process involves a compromise among a large and very diverse set of constituents across the world. Different countries have different goals with respect to financial reporting regulation. While current IFRS are arguably focused on the needs of “outside investor” economies such as the U.K., Australia or the U.S., the majority of the economies around the world still relies heavily on close relationships among a large set of stakeholders and is less focused on outside capital markets. A potential risk for the U.S. and countries with similar “outside investor” models is that the IASB could be influenced to modify IFRS to meet the demands of “inside stakeholder” economies. As a result, future IFRS may be less suited for “outside investor” economies such as the U.S.”
“We expect incentives and institutional factors to remain a driving force of reporting practices in the years to come. Hence, adopting IFRS on a worldwide scale will hardly eliminate all national, industry and firm-level forces and incentives that influence firms’ financial reporting practices. Local capital markets, enforcement institutions and economic forces are simply too strong and diverse, making a uniform implementation of IFRS around the globe highly unlikely. Moreover, globally adopting IFRS likely shifts regulatory competition from the creation of accounting standards to the interpretation, implementation and enforcement of existing IFRS in local markets. These forces could lead to regional versions of IFRS or different de-facto standards. For instance, financial crises, new business practices or innovations in the capital markets can require changes or new interpretations of extant IFRS, which in turn might lead certain countries to opt out or adopt their own version of IFRS. The carve-out of specific sections in IAS 39 (Financial Instruments) during the endorsement process of IFRS by the European Commission in 2004 and 2005 is just one example of 72 such a nationalized version of IFRS, which sets an important precedent. The recent financial crisis presented the IASB with the threat of another EU carve-out.”
The paper is: "Global Accounting Convergence and the Potential Adoption of IFRS by the United States: An Analysis of Economic and Policy Factors."
Friday, April 3, 2009
Macy's market cap today is about $4 billion, down from about $20 billion at its peak in 2007.
Macy’s had previosuly warned of the impairment charge and said the estimate is subject to further adjustment when it completes its calculations in the first quarter of 2009.
The non-cash write-down should not affect Macy’s financing covenants and accordingly will not cause defaults in bank credit agreements or bond indentures.
Macy’s reported operating income of $1 billion but the impairment charge brings their fiscal 2008 loss to $4.4 billion.
The goodwill arose on Macys' 2005 acquisition of May Co., the economic downturn and the decline in market capitalization.
Thursday, April 2, 2009
Congress had threatened FASB Chairman Robert Herz at a March 12 Senate hearing to change the fair-value rules or Congress would unilaterally. FASB came out with changes four days later, and fast-tracked them on a two-week comment period. Investors and accountants opposed the changes.
Arthur Levitt is chair of the Investors Working Group and commented “The group is deeply concerned about the apparent FASB succumbing to political pressures, which prevent U.S. investors from understanding the true obligations of U.S. financial institutions.”
A few reference points in the debate on fair value:
Arthur Levitt’s remarks to Congress
FASB Technical Accounting Advisory Group views on MTM
The long-running campaign by banks against fair value
Summary of the rule changes
Politics and Accounting
CFO Views on MTM
The Politics of Fair Value
A Warren Buffet Advisor’s View on MTM
Former SEC Chair Comments on Independence of Accounting Standard Setters
Wednesday, April 1, 2009
Plenty of banks have succumbed to the credit crunch. Now, accounting rules look set to join the list of casualties.
Accounting rule makers will vote Thursday on proposals to soften "mark-to-market" accounting, the controversial rules requiring companies to peg their investments' value to the market's ups and downs. Many banks blame the rules for worsening their current problems, by locking in losses that they say are merely temporary.
The banks' claims are largely bogus -- after all, no accounting rule forced them to create and invest in the toxic securities that helped cause this crisis. But the Financial Accounting Standards Board is being pressured to water down the rule.
And one of the proposals that the board will vote on Thursday, to relax the standards under which companies must take impairment charges on their "available-for-sale" investments, would be particularly worrying for investors.
Companies record declines in their value of these securities as "unrealized" losses that get assessed on the balance sheet but don't affect earnings or regulatory-capital levels.
If the losses are later determined to be "other than temporary," however, companies must take impairment charges that lower net income and regulatory capital.
FASB's proposal makes it much less likely that stressed banks would take those charges in a timely fashion. Under the plan, all banks would have to do is say they don't intend to sell an "available-for-sale" investment that has incurred mark-to-market losses and probably won't be forced to sell before it recovers. Then, only "credit losses," the amount a company expects to lose if it holds an investment to maturity, would have to be recognized in earnings. The other declines in market value would only go onto the balance sheet, as now.
That could be very important for some banks where toxic securities, with serious mark-to-market losses, comprise a big part of the capital structure. The unrealized losses on "available-for-sale" securities in effect for at least a year are equivalent to 6.6% of risk-weighted capital at U.S. Bancorp and 3.2% at Wells Fargo. That is another reason why investors should focus on tangible common equity as a capital measure instead, which does include such unrealized losses.
A rule change would be good for the banks -- not good for investors who need accurate valuations of companies' assets, reported clearly, on which to base their investment decisions. In fact, making things easier on the banks may only make already-cynical investors even more suspicious of the numbers that the banks are reporting.
This is happening now because of pressure on FASB Chairman Robert Herz from politicians who, at a recent hearing, threatened to eviscerate fair-value accounting if the changes didn't happen. So it isn't just the fair-value rules that are at stake here -- it is FASB's independence in setting all accounting rules. The risk is that plans to water down mark-to-market rules are only the start.
By Michael Rapoport at the Wall Street Journal.