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Saturday 18 December 2010

When 'making the numbers' makes sense

"Short-termism" – an ugly phrase for an ugly approach to management – is widely blamed for everything from asset bubbles to outsourcing. There's a argument, of course, that the long term is just the sum of all short terms, but when it comes to deciding on a specific project or investment, the outcome often differs radically based on which stance you take. The issue becomes more complex when investors (or at least certain types of investor) agitate for performance over a narrow time horizon. Corporations face constant demands for guidance on "the numbers" – the quarterly or half-yearly earnings report – and then get punished by markets (or really by certain types of market trader) when they fail to meet them. "Making the numbers" is a mug's game.

Or is it? According to a study by scholars at MIT and Harvard, there are conditions – a "tipping threshold" – above which is makes sense to make the numbers by focusing on the short-term at the supposed expense of longer term consideration. "We show that if the source of long-term advantage is modeled as a stock of capability that accumulates gradually over time, a firm's proclivity to manage short-term earnings at the expense of long-term investment can have very different consequences," they write. When the company operates above the threshold, earnings management can smooth revenue with few long-term consequences. "Below it, managing earnings can tip the firm into a vicious cycle of accelerating decline. Our results have important implications for understanding managerial incentives and the internal processes that lead to sustained advantage," they conclude.

Source document: The working paper "Making the Numbers? 'Short Termism' & the Puzzle of Only Occasional Disaster," by Nelson Repenning of MIT and Rebecca Henderson at Harvard, is a 39-page pdf file.

FEE responds to EU audit green paper with 'wait and see'

The European Commission wants ideas for what it should do about auditing in response to the financial crisis. The European Federation of Accountants thinks it may be well to do nothing, more, for now. The federation, known by its French acronym FEE, has issued a 59-page response to the European Union's green paper on audit. Green papers aren't intended as policy statements, more as calls for evidence, and among the evidence FEE presents is that a lot of changes already undertaken with respect to audit haven't yet come fully into effect. The EU's Statutory Audit Directive only became law in member states in 2010, it noted. The International Standards on Auditing are in force, but only for accounting period that begin after December 15, 2009, so in effect they haven't been through even a single cycle. "FEE also stresses that the majority of matters related to the audit market and the audit process have to be considered at a global level," it said. "There is a need for enhancing global convergence in relation to audit regulation, audit standards and ethical standards."

Source document: The FEE submission is a 59-page pdf file.

IASB issues guidance on talking about the business

"Management commentary" has been on the agenda of the accounting standard-setters for quite a while, but now there's movement. The International Accounting Standards Board has issues a report discussing the findings of its consultations on what such non-financial reporting should look like. This "broad, non-binding framework" suggests what companies should do to provide a narrative about the business to complement the numbers reported under international financial reporting standards. "Management commentary fulfils an important role by providing users of financial statements with a historical and prospective commentary on the entity's financial position, financial performance and cash flows," the IASB said. "It serves as a basis for understanding the management's objectives and strategies for achieving those objectives."

Nature of the commentary: For readers of corporate annual reports, the concept of a management commentary is already well understood. The "operating and financial review" that many UK companies provide, the "business review" that listed companies around the European Union are obliged to produce, the "management discussion and analysis" that UK companies need to present are all examples of the genre. But the IASB's intention is to make sure that genre doesn't turn into fiction. Sir David Tweedie, Chairman of the IASB, said: "Management commentary is one of the most interesting parts of the annual report. It provides management with an opportunity to add context to the published financial information, and to explain their future strategy and objectives. It is also becoming increasingly important in the reporting of non-financial metrics such as sustainability and environmental reporting."

For whose benefit? This question has long been the rub in financial reporting. Audited financial statements, for example, give comfort to creditors, including suppliers, employees, prospective employees and many other people than the shareholders for whom they are intended and who ultimately pay for the work done to produce them. Management commentaries are used by all sorts of people to assess the company as a business partner or even as a neighbour. The IASB's framework suggests taking this approach: "Management should determine the information to include in management commentary considering the needs of the primary users of financial reports. Those users are existing and potential investors, lenders and other creditors." The rest of you can look away now.

Look forward! Management commentaries aren't merely recitations of past performance. In a section called "Forward-looking information" the IASB writes: "Management commentary should communicate management's perspective of the entity's direction. Such information does not predict the future, but instead sets out management's objectives for the entity and its strategies for achieving those objectives. The extent to which management commentary looks forward will be influenced by the regulatory and legal environment within which the entity operates." Companies may, but are not required to, present forecasts or projections.

Source document: The IASB framework for presentation is a 28-page pdf file.

UK audit committee guidance voices special role

The UK Financial Reporting Council has issued new guidance to audit committee, making clear that audit committees have a special duty to shareholders. "While all directors have a duty to act in the interests of the company the audit committee has a particular role, acting independently from the executive, to ensure that the interests of shareholders are properly protected in relation to financial reporting and internal control," the guidance states. That role is described quite consciously in terms of oversight, rather than action, and the FRC is quick to note that nothing in its guidance should detract from the notion of a unitary board. "However, the high-level oversight function may lead to detailed work. The audit committee must intervene if there are signs that something may be seriously amiss," it says. "For example, if the audit committee is uneasy about the explanations of management and auditors about a particular financial reporting policy decision, there may be no alternative but to grapple with the detail and perhaps to seek independent advice."

Cognitive conflict? This approach may not threaten the unitary board. UK companies have lived with increasingly independent audit committees since the Cadbury Report in 1992, and when audit committee members join meeting of the full board they live with the internal conflict of overseeing the accounts as well as contributing to the policies that go into to making them. But stressing the independence of the audit committee involves stressing the role for cognitive conflict between board members, which can lead to divisions. Audit committee members will need to do more work than other board members, and the FRC thinks they should be paid more, too. Financial expertise comes at a premium.

Source document: The FRC audit committee guidance is a 28-page pdf file.

Tighter ethical standards for audit on the way in UK

Auditors in the UK face tougher ethical standards in the wake of a review of their code of conduct. Revisions by the Audit Practices Board came in response to the financial crisis and its aftermath, in which clean audit reports were followed by rapid collapses of banks and other financial institutions. One focus of the changes is on the level and nature of non-audit work that the audit firms undertake for clients. "Respondents to the APB's consultations on its Ethical Standards indicated that a total prohibition was not appropriate but acknowledged that there can be a perception of a loss of independence where certain non-audit services are provided by the auditor," the APB said. "This is heightened where the ratio of non-audit fees to audit fees is high."

The APB doesn't want to set in stone a formula for deciding when enough is too much. Instead, it lends moral force to the audit partner's control of the client relationship, rather than other members of the firm who might gain work from the client. In boldface type, it notes: "The audit firm shall establish policies and procedures that require others within the firm, when considering whether to accept a proposed engagement to provide a non-audit service to an audited entity or any of its affiliates, to communicate details of the proposed engagement to the audit engagement partner." The audit partner should then apply a "reasonable and informed third party" test, and then consider the likely risks to the firm's reputation, before assessing the safeguards in place to deal with those risks. Only then should the firm take on the work.

Source document: The news release has links to the documents.