Archive for April, 2009

Seeking wisdom is always a worthwhile pursuit.  The trouble is, most people look for it in wrong places. 

This week we had the distinct pleasure of interviewing Dr. Thomas Taylor, Professor Emeritus of Accountancy at Wake Forest University.  His interests include the development of accounting reform and the market economy in post-Soviet Russia, strategic cost management, and financial reporting and analysis.  

Dr. Taylor holds degrees in accounting, economics and the history of economic thought.  Dr. Taylor has also had an interest in Russia, teaching accounting courses and conducting research there, and setting up a faculty exchange with a Moscow business school after the dissolution of the Soviet Union.   

We found Dr. Taylor’s insights to be extraordinarily compelling, interesting and thought provoking.  We share excerpts of our conversation below.  

Weekly Recon: Very often we find there is a tension in companies between the demands of financial reporting and management accounting.  Take us back to basics, what is the central role of accounting in a free market?

Users of financial information clearly need market data that will drive decisions.  Looking at accounting from a management point of view, if accounting data cannot be used for decision making purposes it’s not much good.

In recent years I have focused on the use of accounting information by managers in profitability analysis, make/buy decisions, measures of performance, capacity costs, and the like.  These are important areas for managerial decision making.

The only constraint in this area of accounting is cost/benefit.  The decision on how much accounting information is necessary is a subjective one and can only be made by accounting users and on a company-by-company basis.

As far as external financial reporting, we have to be careful not to get trapped in rule-oriented reporting requirements that are costly to implement and that often do not provide any additional value to users.

Accounting guidelines need to be more principles-based or concept-based to allow for greater professional judgment.  Accountants need to be professionals and exercise their careful judgment based on their expertise and experience.  An analogy would be preferring our doctor to use professional judgment and not just some manual produced by the AMA.

Weekly Recon: Lets go a little further here, do you believe that all the of the financial reporting data that public companies produce is used by investors?

There is sometimes a lack of understanding of accounting by the investment world.  On the most basic level, the word accounting means to account, not for the future, but for the past and the present.  There is an expectation in the investment community, and a frustration amongst accountants, regarding the use of accounting to predict future events.  By definition the future has not yet happened, hence you cannot account for it; you can only speculate about the future.

Of course we have to make some reasonable predictions such as the useful life of fixed assets, doubtful AR , etc., for which we have some solid historical record.  Some of the accruals and disclosures accountants are asked to make are really based on speculations about the future.  One of the basic precepts of economics is that the future is unknowable.

Accounting is necessarily very attuned to Wall St’s information needs because of the significance of the capital markets to the economy.  Yet internal or management accounting in many cases has been subordinated to external reporting for investors and creditors and is driven by SEC and FASB requirements.  These reporting costs are so substantial that sometimes good management accounting gets short shrift. 

Weekly Recon: So what should be the relationship between accountants and investors?

Investors should take the historical data, which should reflect current economic evaluations as much as possible, and use it for whatever purposes they choose.  It’s really the investment community’s job to speculate and forecast the future.  Investors should be dealing with the uncertainty inherent in investing and not looking to accountants to tell them what the future holds via reserves, contingencies and the like, which often are used to “manufacture” earnings and earnings trends. 

Of course this is not to say that accountants should hold back information that in their judgment has potential relevance to the users.  We need to disclose as much as possible without giving away competitive information or making absurd predictions.  

Wall St often likes to see smooth quarterly earnings which is not reality in many cases.  It puts pressure on management to use accounting to obtain some predetermined result.  For example, years back I was performing an audit and the CFO came into the room and actually wrote on a chalkboard the earnings per share that he expected the audit team to find acceptable.  

Weekly Recon: You mentioned being less rule bound and bringing more judgment back into accounting.  Can you give us an example of what you mean?

The greatest principle we have abandoned is that of Full Disclosure.  For example, let’s take off-balance sheet debt.  Looking back at the Enron situation, they had a large number of what are called “special purpose entities” (SPEs).

It is my understanding that if a company convinces an outside party to put up a tiny portion of the equity of the SPE, something like 3% I believe, then the company does not have to reveal the SPE’s debt on its balance sheet.   This is a great example of following the rule and abandoning the principle.  People can find a way to get around a rule much more easily than getting around a principle. 

Weekly Recon: This leads us to the larger question of who should be setting accounting standards

Since its founding in the 1930’s the SEC has held the legal authority to set all accounting standards for publicly-owned companies.  Fortunately the private sector has been allowed to be the dominant influence on accounting standards primarily through the Financial Accounting Standards Board (FASB).  There is a growing threat that the hand of government will reach further into standard-setting.  This can only mean a greater degree of rule-based, bureaucratic accounting.  Just think of how income-tax laws and regulations have evolved over the years to include many and varied rules without much underlying principle. 

Weekly Recon: Tell us about your experiences with accounting in Russia

Russia is absolutely fascinating to me because I had the chance to witness the start of a transformation from socialism to a form of market capitalism. 

I have taught MBA, business and accounting courses in Russia and set up a faculty exchange with a ‘westernized’ business school that was established within an institute which many years ago was set up by Stalin to train the KGB.  It was amazing to me to stand in front of Russians and talk about “capitalist” profit and loss.  They were extremely interested in understanding how a legitimate market works and what the role of investors and risk takers is in a market economy. 

Since privatization, things have continued to change dramatically.  Yet the progress in accounting reform has been slow.  In Russia the Ministry of Finance dictates accounting standards.  The old Soviet accounting of measuring inputs without regard to market-valued outputs is still ingrained in their mentality and makes for slow improvement of accounting in many Russian companies. 

In 1996 the Ministry did; however, call for the adoption of international accounting standards by all publicly-traded companies by a certain date.  So at least the door was opened to proper accounting as followed in modern economies.  Also, many leading western corporations with operations in Russia and some major Russian companies have taken steps to folIow international accounting standards.  This is encouraging and necessary for Russia to attract more foreign investment so badly needed there.  

Accounting has a cultural role in society and has to mirror the level of development of a country.  Under socialism real accounting was non-existent.  During the early years after the collapse of the Soviet Union (early 1990’s), a lot of bartering was going on because there was not much trust.  Trust is essential to a free market economy.  For example, when you don’t have trust you can’t have an accounts receivable.  So that aspect of accounting was not applicable then.

Weekly Recon: What is the situation in Russia today?

Today, at the multinational level there is not much of a problem.  They have effective controls and well-trained people.  They also have some very good schools in Russia that are training young Russians in the profession, such as the Russian Finance Academy in St. Petersburg and the Institute for Business Studies in Moscow, where we have a faculty-exchange program. 

I think at the end of the day the human instinct to trade and take risk, to learn and make money, will overcome any obstacles that remain.  But it is a slow process of institutional change.

Taxation still drives much of the accounting.  There is an order of concerns in Russia when it comes to accounting.  The first concern is taxation, second is serving the investment community using IFRS (International Financial Reporting Standards) or GAAP (Generally Accepted Accounting Principles), and third is internal management accounting. 

The lower ranking of the latter is due to the need for capital investment which is driven by external accounting information, while the emphasis on tax reporting stems from the force of government.  It is unfortunate that managerial accounting is relegated to last place, but hopefully this will change as management users demand more information for decision making purposes in a more competitive market economy. 

Weekly Recon: Do you see IFRS moving forward in light of recent economic events?  Would moving forward cause undue burden on companies when times are already tough?

Yes, the extensive amount of globalization in the world today demands it.  I think it will be still a slow process of achieving congruence for many countries.  And transitioning over to IFRS for U.S. companies will be costly.  At the university we are facing the need to phase IFRS into our curriculum in the near future.  Next week we will have a major lecture on campus by the current Chairman of the FASB on the topic of IFRS.

Weekly Recon: What are the critical qualities one should look for in accountants?

I think that first they should have a clear understanding of, and appreciation for, the critical role that accounting plays in a market-oriented society, namely to facilitate market-driven decisions by managers (insiders) and by participants in the capital markets (outsiders). It takes both to make the market economy function.  With that understanding the focus should be on the best way to deliver the information needed.  A commitment to the principles of Full Disclosure and Objectivity is crucial.

Weekly Recon: What do you think would be valuable right now for companies?  What are they looking for from consulting companies?   

Great question!  I suppose that with the picture so clouded now with the turmoil in the financial markets and the spillover into all other markets, trying to figure out which way to go is a monumental challenge. 

Specifically, companies are striving hard to get a handle on the prospects of changes at the macro level such as new regulations, new tax policy, new international trade policy, etc.  This is an ongoing task that is much more difficult than under more normal circumstances. 

Consulting firms that offer solid value for the fee and deliver badly needed results should be ideally placed in this market. 

Weekly Recon: Is that a blanket endorsement of Granite?

Not quite, but I am sure you’ll do fine Mike. 

Weekly Recon: Thank you Dr. Taylor

Thank you. 

We have such a fast moving and “here and now” culture.  In almost every facet of our lives the focus is on present gratification, mostly at the expense of the future.  We eat fast food that tastes good now and makes us sick later and over spend on consumer goods today, only to amass a mountain of debt for tomorrow. 

There seems to be one area that is unaffected by this preference.  In this area we have such a full and unshakable faith in the future that we actually shun the present.  This area is none other than investing. 

Let’s take equities for example.  Businessmen, housewives, teachers, carpenters, all comment on the stock market.  Did it go up? Did it go down?  Inherent in this incessant market watching is a significant expectation of capital appreciation. 

Many people have been inculcated by today’s investment gurus, financial television programs and personal finance celebrities to expect price appreciation as their reward for investing in equities.  To be sure, price appreciation is one reward of investing, but certainly not the only reward.  Indeed price appreciation has historically not been the primary goal of investment. 

In days past investors bought shares of stock in return for a share of the profits of the enterprise.  Put simply, investors expected dividends and healthy ones at that.  Today most investors purchase a stock in the expectation that the share price will increase and the stock will later be sold for a profit.  Dividends are almost an afterthought. 

The difference is not insignificant and directly impacts not only how we perceive our capital markets but also our success as investors. 

PE ratios for the S&P500 have averaged approximately 26 over the past 10 years.  It’s actually amazing to stop and think that investors do not balk at paying 26 years earnings for a stock.  This means that the investor will have to wait 26 years before they recoup their share of earnings and this does not even take into account inflation because…well that’s another story for another time. 

Instead of dividends, today’s investor has turned almost completely to capital appreciation.  In their mind it doesn’t matter that it will take 26 years to recoup their investment in earnings because they are counting on significant price appreciation. 

It’s amazing that in other areas of our life we demand so much immediate satisfaction yet when it comes to making money we depend solely on future price appreciation that may or may not happen.  Understanding the bias towards price appreciation also makes understanding the behavior of our capital markets easier.  

Price appreciation can best be influenced in the short term via the perception of other investors.  Enter the conference calls, analyst opinions, accounting adjustments, corporate road shows, etc.  Influencing investor perception creates tremendous pressure on corporate managers to meet this quarter’s earnings estimate and also creates the temptation to do what is necessary to attain this goal. 

In response to these pressures and temptations we have various investor “protections” and external reporting requirements that have been put into place.  Devices such as Sarbanes-Oxley and FIN48 were enacted to supposedly guard investors and prevent management manipulation of earnings.  These measures are very costly for companies to implement, have questionable effectiveness and are little understood by the average investor. 

Perhaps the best investor protection is to demand a real return on investment.  A return that cannot be masked, is tangible and easily measured.  What might this be?  None other than the oft forgotten, and much maligned, cash dividend payment.

If the focus of investment was on a real return in the present, there might be less focus on attaining quarterly numbers, predictable earnings trends and non cash events.  More attention might be paid to the board’s selection of management, the company’s business model and the ability to generate cash. 

Apart from equities, the preference for capital appreciation over present return extends to the real estate market as well.  Over the past years, much of the focus was on flipping properties for a profit.  Moreover the traditional linkage of real estate prices to rental income was severed as buyers were influenced by the crooning of real estate agents saying, “Real estate always goes up.” 

I met an old friend at a party recently who owns a portfolio of residential rental properties.  The man is an attorney by trade and has worked for various companies in the area where we reside. Over the years he steadily built up his portfolio of real estate holdings. 

He commented to me on the astounding number of people who advised him in 2005 and 2006 to sell his portfolio and make a bundle while the market was hot.  As he was telling the story, even I thought it might have been a good suggestion. 

Maybe it was the beer or maybe it was the late hour, but at any rate I asked him, “So why didn’t you sell?”  He answered my question with another “Where would I have put the money?”  As I pondered his comment he finished by saying, “Besides I don’t really care what the values of my properties are. I am in this for the income.” 

As his response sunk into my mind, I realized the wisdom of his words. 

The recent bear market rally notwithstanding, equities are in serious trouble, Treasuries are offering a negative real rate of return, corporate bond default rates are skyrocketing and even commodities have taken a hit.  

Getting back to the party and the conversation with my friend, I asked my final question of the evening. 

“So where are you working now?” I asked. 

“Mike….. I don’t need to work anymore”, he responded softly.   

Until next week,

Michael Bechara, CPA

Managing Director

Granite Consulting Group Inc.

mbechara@consultgranite.com

www.consultgranite.com

We have often wondered what motivates companies to obtain government bailouts rather than just slog through bankruptcy court.  On the surface it is an obvious decision.   Why go through the trouble and expense of a court proceeding when you can simply take money from the taxpayers?

Ah, but so much of life’s answers lie below the surface.  The surface is where the lightweights hang around.  They toss clichés at one another such as, “Whatever works” and “Take the money and run!”  Its only when they are rudely awakened by (easily foreseen) consequences that they realize the folly of their decisions. 

It is quite apparent now, even to the surface dwellers, that the receipt of government money means giving up control of major company decisions.  Another point, not so obvious, is that the bailout mentality becomes institutionalized amongst the company and its counterparties. 

These points can be easily illustrated by comparing two automotive companies; General Motors and the Ford Motor Company. 

GM

The administration’s firing of GM CEO Rick Wagoner was one of those “have we crossed the Rubicon?” moments. 

I spoke to two friends that day, one a corporate development executive and the other an investment manager.  Both are what I would call “big picture guys” and have consistently provided very lucid analyses of world events.  There was no ranting or raving from these gentlemen, rather there was a kind of quiet bewilderment, almost a disbelief that we have reached this point. 

Of course, everyone logically realizes that the event is not all that surprising.  GM requested additional money from the federal government and the government would not grant the money without certain conditions being met.  If the government wants management changes at GM as a condition of receiving further money, then they are certainly within their rights to demand this. 

It is stunning nonetheless to witness the CEO of a major company being removed by politicians.  Moreover, this particular firing seemed misdirected in many ways.  Kind of reminds us of the cop shows from the 70s when the eager detective brings in a low level perpetrator while the big fish remain at large. 

We can’t comment on whether Mr. Wagoner was a good CEO or not.  Under normal circumstances that would be for the Board of Directors to decide.  We do know; however, that there are many bank CEOs who have taken billions from the Treasury, greatly mismanaged their companies and remain happily on the job. 

What about excessive pay?  Was that the reason?  

For 2009, Mr. Wagoner’s salary was set at $1.  The media is currently outraged that Mr. Wagoner is keeping his pension of $22 million.  Rick Wagoner spent 32 years at GM working his way up through ranks and devoting his life to the company. 

Contrast this with Alan Fishman.  The Washington Mutual CEO received roughly $20 million in cash.  He was employed by WaMu for 17 days.  Of course there was outrage over Mr. Fisher’s pay…right?  We listened carefully at the time and heard only the sound of crickets. 

Let’s move on and look at the difficulty GM has had in restructuring its debt.  The debt holders, rather than negotiating a settlement or accommodation with GM, are hardening their position in light of the government’s support of GM.  We quote from the Detroit Free Press:

Talk that the government is not looking to push GM into bankruptcy could be making negotiations with bondholders more difficult, industry observers said.

“The financial bailout and the rhetoric could, in our view, harden bondholders’ positions as they may see reduced risk of bankruptcy-driven losses in the value of their holdings,” Efraim Levy, an equity analyst with Standard & Poor’s, said in a note.

This is a perfect example of what we mean by the “institutionalizing” of the bailout mentality

GM’s creditors, seeing that the company has government support, have internalized the idea that more funding will always be forthcoming.  They certainly have no incentive to strike any deal now, especially with the concept of “too big to fail” looming in everyone’s minds.   

This expectation of continued support seems to prevent market participants from making the sacrifices they would normally would, in order to best extricate themselves from financial harm. 

Ford

We now turn to Ford, a company that did not receive government funds.  So how has this company faired lately?

Ford cancelled all bonuses and merit increases for all employees in 2009 – including top management.  Ford CEO, Alan Mullaly, will take a 30% pay cut this year and next.  The Board of Directors will receive no cash compensation in 2009. 

It seems that Ford is employing the management team it wants and is requiring them to making the sacrifices necessary in a very tough market. 

Ford also recently negotiated a deal with its debt holders and plans to pay down 44% of its debt at 47 cents on the dollar.  In fact, Ford originally planned to pay back less than half this amount but its debt buyback program became oversubscribed!  This means more debt holders rushed to take Ford’s offer than anyone originally expected. 

Companies can find their own way through their difficulties by using existing market mechanisms.  In the Ford example, the creditors and debtor have independently evaluated the situation and have come to an agreement.  An agreement that each party believes best serves its economic interests. 

Something tells me the Ford family wouldn’t have it any other way.  Especially after all the trouble old Henry went through. 

In late 1919, in order to gain complete control of Ford Motor Company, Henry Ford started another company, Henry Ford and Son.  He made sure the minority shareholders of Ford Motor knew that he was leaving and was taking the best employees with him.  Realizing that the value of their shares was in jeopardy, the minority shareholders sold out to Henry and subsequently gave the Ford family sole ownership of the company. 

Even today, the Ford family holds a special class of shares that entitle them to 16 times the voting rights of ordinary shares.  I think that someone at Ford thought carefully and deeply about the consequences of taking government funds.

Perhaps the Ford family knows the old saying.  If you invite strangers to the party you might have to listen to their advice. 

Until next week,  

Michael Bechara, CPA

Managing Director

Granite Consulting Group Inc.

mbechara@consultgranite.com

www.consultgranite.com