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Too Much of a Good Thing

The death knell sound for contingent convertible bonds; should there be a ''little GAAP''?; Section 409 debuts -- pass the aspirin; more.
CFO Staff, CFO Magazine
September 1, 2004

"This came totally out of the blue for us," is how John Devine, CFO of General Motors Corp., speaking during the company's second-quarter earnings call, summed up what many CFOs must be thinking about a recent rule change proposed by the Financial Accounting Standards Board.

The rule concerns contingent convertible bonds ("Co-Cos," for short). They work like regular convertible bonds, with a small — but crucial — difference. Unlike a standard convertible, which an investor can trade in for stock at a fixed price whenever it makes sense, Co-Cos can be converted only when the share price reaches a certain target. This distinction allows the bonds to slip through an accounting loophole: the securities don't get factored in diluted earnings per share until the stock price hits the target. "These are used purely to avoid upfront EPS dilution," says Chris Senyek, an accounting analyst with Bear Stearns. "There's no other economic significance to the contingent feature."

Now FASB intends to shut the loophole. If the proposed rule goes into effect, companies will have to record an increase in shares outstanding on the day they issue a Co-Co, thus reducing EPS. And the change would be retroactive, a step the board generally reserves for particularly egregious accounting practices, says Dennis Beresford, professor of accounting at the University of Georgia and FASB's former chief.

This last point explains Devine's consternation — GM predicts that because of already issued Co-Cos, its EPS will drop by $1, down 14 percent from its 2004 target of $7 per share.

GM isn't alone. Delighted by the prospect of cheap financing and delayed EPS dilution, companies now issue more Co-Cos than regular convertible bonds. According to Bear Stearns, in fact, 84 percent of convertible bonds issued this year contained a Co-Co provision, up from 65 percent last year.

As FASB mulls its final decision, companies are looking for ways to avoid the hit. One alternative, which GM plans to pursue, is to settle its Co-Cos using cash rather than shares (possible only when the bond includes such a provision). As for Co-Cos themselves, this looks like their end, says Senyek: "I expect the use of the contingent feature to drop off almost completely." —Don Durfee


One Size Fits All?

Should there be a "little GAAP"?

That's a question the American Institute of Certified Public Accountants is currently tackling. Last winter, the New York-based professional organization formed a Private Company Financial Accounting Task Force to determine just how well generally accepted accounting principles are working for different stakeholders.

"The debate [over little GAAP] has been around for 30 years," says Daniel Noll, the AICPA's director of accounting standards. What's made it more pressing now, he explains, is that since Sarbanes-Oxley, some smaller firms believe that "GAAP focuses more on public companies." Moreover, it is not clear that lenders and investors actually find GAAP reporting at private companies relevant to their decision-making process.

The task force is surveying numerous constituents — including CFOs — on their views. "If it turns out GAAP is working properly, our work is done," says Noll. But if it's not, the task force will draw up recommendations on how to refine GAAP to present to FASB and others. —Lori Calabro


Spurning the CFO Act

Some think it was just an oversight that the Department of Homeland Security, created two years ago, became the only cabinet-level agency not subject to the CFO Act of 1990. Indeed, bills in both houses of Congress now seek to apply the act to the DHS — which would require Senate approval for its CFO and setting standards for departmental audits. And the Government Accountability Office (GAO) calls passage of the bills "of critical importance."

One adamant opponent of applying the act at the DHS, though, is Andrew Maner, the agency's CFO. "Everyone is quick to make us like the other departments," he says, but they "ought to give [us] a chance to do things our way." The DHS "way" has involved voluntarily launching an audit, though one lacking the complete internal-controls reviews the CFO Act mandates. And, of course, Maner's appointment by President Bush didn't require Senate approval.

Maner — former chief of staff to the U.S. Customs and Border Protection commissioner, and before that a press officer for President George H.W. Bush — calls Senate confirmation "unnecessary" and potentially obstructive. The Defense Department, he notes, recently suffered through not having a controller because confirmation was held up. Besides, he asks, "What better way is there to do the job than to just get a CFO in and get things working?"

No one doubts that finance has worked hard to combine 22 agencies into one $40 billion department. "There's no handbook that exists that tells you how to do this. We're trying to integrate and get on one system," says Maner. The voluntary audit, he adds, was a major achievement and identified material weaknesses now targeted for repair.


Still, in Sen. Peter Fitzgerald's (R­Ill.) view, the DHS's complexity is an argument for tougher controls in light of "the many challenges it faces in integrating the financial systems from its legacy components." And auditing controls "is necessary because it places additional pressure on management to identify and correct [problems]." The GAO's McCoy Williams, director of financial management and assurance, adds that the CFO Act should be "the gold standard" to follow.

But Maner is undeterred. "I'm just not sure of the cost-benefit of doing internal-controls audits in the public sector," he says, noting that the GAO provides some of that function. He suggests an independent study to determine whether the advantages of such audits outweigh the disadvantages. —Roy Harris


Does Fraud Equal Loss?

It's as predictable as anything about the stock market: when a company's share price plunges, shareholders sue. But launching a successful shareholder suit — that is, one that gets settled — may soon become harder.

The U.S. Supreme Court has agreed to review a decision in a case that pits shareholders against Dura Pharmaceuticals Inc., a drug firm now owned by Ireland-based Elan Corp. At issue is a fundamental question: When fraud occurs and investors lose, how do you prove the link between fraud and loss?

Currently, courts in the United States use two competing standards. Under the first, the plaintiff needs to show that disclosure of the fraud caused the price to fall. The idea is that when a company fakes the numbers, its share price will be artificially high. When the lie is exposed, the price should come down. "It's not perfect — economists will argue about the factors behind a price drop — but it addresses the need for a plaintiff to prove that wrongdoing was the cause of the loss," says Michael Gass, partner with Boston law firm Palmer & Dodge LLP.

The second standard is looser. This approach — at issue in the Dura case — says it's enough to show that the stock price was inflated due to fraud. Then, any loss that occurred during that time is fair game for a lawsuit.

Not surprisingly, public companies hope the Supreme Court strikes down the more lenient standard, a move that could make it easier to have suits dismissed. "Companies spend a lot of time and money on cases that end up getting thrown out," says David J. Elliott, a partner with Day, Berry and Howard in Hartford. "I'm not troubled by putting plaintiffs to a higher burden of proof."

Is there a risk that such a decision could set the bar too high? After all, such suits are weapons for combating corporate wrongdoing. Elaine Buckberg, an economist with NERA, doesn't think so. "If you have a big case involving material fraud, the market will have a statistically significant reaction when the truth comes out." — D.D.



Going with the (Free-cash) Flow

More companies are tying incentive pay to performance in an up-and-coming metric: free-cash flow (FCF). Bausch & Lomb, Motorola, Kraft Foods, and American Standard are among those that are linking pay to cash available after operating activities.

Proponents say it is a better indicator of overall company performance and less easy to manipulate than net income. "The problem is that it is so easy to manage earnings," says Charles Mulford, director of the Georgia Tech Financial Analysis Lab. Techniques such as channel stuffing, selling off investments, and tapping into reserves, he adds, can't manipulate FCF as easily.

The metric is also more controllable than share price. "Sometimes the share price is really outside management's control," says Mulford. "They feel that they are at the mercy of the whims of the market."

FCF is calculated by adding depreciation and amortization back to net income, subtracting the net change in working capital, and then subtracting capital expenditures. More simply, it is found by subtracting capital expenditures from cash flow from operations. FCF is the cash available after operating activities to pay down debt, issue dividends, buy back stock, or invest.

American Standard Co., a Piscataway, N.J.-based manufacturer of kitchen and bath fixtures, added FCF to its list of incentive-pay measures when it intensified its campaign to pay down debt. "It has worked extremely well," says Noreen Farrell, director of corporate compensation. The company has reduced debt by nearly $1 billion since it started using the measure in 2000. In addition to FCF, American Standard ties compensation to sales growth, gross margin, and net income. The four metrics make up 70 percent of the incentive; 30 percent is decided by nonfinancial measures.

FCF is not infallible, however. Managers can game it by delaying vendor payments or securitizing receivables — two activities Mulford advises companies to watch out for. —Joseph McCafferty


Benefits on the Fast Track


Companies finally have a regulatory blueprint for how to use their captive insurer to fund benefits programs. Now the question is, how many will take advantage of it?

Last November, International Paper became the first company to receive "fast-track" approval from the Department of Labor to fund its group life benefits through its existing property/casualty captive.

Under the new process, if a company satisfactorily copies precedents set in two previous cases — one involving Columbia Energy Group and the other Archer Daniels Midland — it can receive DoL approval within 75 days. IP hired a highly rated primary insurer, Metropolitan Life Insurance Co., as well as an independent fiduciary, U.S. Trust Co., and improved its benefits package to gain the DoL's blessing.

Having the fast-track process, says Rich Fuerstenberg, a consultant with Mercer Health and Benefit Services, paves the way for firms to realize the promise of captives, which includes a better spread of risk as well as possible tax savings. Previously, he notes, the DoL effectively prohibited such funding.

To qualify, he explains, a firm had to allow no more than 50 percent of its business to be related to itself, and since "typically a captive is for insuring related risk," that was nearly impossible. Moreover, the DoL was wary of a company being both the owner of the captive and the fiduciary of the assets — a scenario that was viewed as "the fox guarding the henhouse," adds Fuerstenberg.

Now that the fast track is in place, many consultants report an increase in firms requesting feasibility studies, says Karin Landry, managing partner at Spring Consulting Group LLC in Boston. "While companies can look at funding any benefits out of its captive," she explains, "some, such as life insurance and disability insurance, are more conducive [to the process] than others." Sorting through what works and what doesn't takes time, she adds, noting that there are already a number of companies following IP's lead.

Mercer Human Resource Consulting's Paul Shimer adds that firms must also weigh the "added costs built into the ruling." For example, there are costs associated with extending benefits that are reinsured to the captive, as well as with hiring a third-party fiduciary. In addition, if a firm doesn't already have a domestic captive set up, say in Hawaii or Vermont, it cannot qualify for fast-track approval. —L.C.


Real-time Headaches

Finance has always been cautious — now maybe more than ever. As of August 23, companies have 4 business days to report events that could have a "material effect" on their financials rather than the previous 5 business days or 15 calendar days, depending on the event. Moreover, under Section 409 of Sarbanes-Oxley — "Real Time Issuer Disclosures" — the Securities and Exchange Commission has added eight new triggers for the resultant 8-K filings.

Of course, CFOs have never blithely decided whether a material event warranted an immediate 8-K or could wait until the quarter's end to be disclosed. Take Mike Gersie, CFO of Principal Financial Group. Even before Section 409, he says, the insurer had been "turning over rocks" to disclose potentially significant events. In December 2001, for example, Principal issued an 8-K saying it was reviewing its $171 million investment in Enron, notes Gersie, even though it was a small part of its portfolio.

While such a disclosure predates Section 409, the firm is stepping up efforts to provide thorough reporting, adds Gersie. A few times a month, Principal's finance team calls the CFOs of its business units to ask about unexpected changes. And Principal is formalizing how it decides which events to report.

Such actions make sense. The expansion of what must be revealed means new judgment calls must be made. The result, says Anne M. Marchetti, practice director of Parson Consulting, is that under Section 409, CFOs might well look at numerous events daily and ask: "Is this a reportable condition?"

Is This Anything?
Just deciding what "material" means is problematic. In a 1999 staff accounting bulletin, the SEC said an event is material "if there is a substantial likelihood that a reasonable person would consider it important." The commission also curbed the use of "rules of thumb" — such as 5 percent of net income — as gauges of how big a misstatement must be before reporting is required.

While the SEC bulletin does list several reasons that a misstatement below 5 percent could be material, it is still broad. The problem with that, says George Victor, director of accounting and auditing at Reminick, Aarons & Co., is, "you can't have 12 people with 12 different standards" of materiality. Even though rigid cutoffs should be shunned, he advises, "you have to eliminate as much [variation] as possible so that everybody is reading off the same page."

To further complicate matters, the term "material definitive agreement" still needs defining. The SEC has indicated that a definitive agreement is a "binding agreement," according to Larry Spirgel, an attorney with Morrison & Foerster LLP. But what constitutes a "material definitive agreement," he says, "could have a dramatic effect on how companies disclose mergers."


Fashionably Late
So what can executives do to manage the risk of being caught by a material event? One possibility is simply to file late. Under a safe harbor, in fact, the SEC gives late filers a pass until the end of their current reporting period on some triggers. A late filing won't cost a firm its eligibility to file an S-2 or S-3 short form when it raises capital — and thus it won't have to interrupt the process to issue the longer S-1. In contrast, there's no protection for incorrect reporting.

Some executives are taking a longer-range approach. They hope to uncover problems early by scanning operating-unit data. Each morning at Cognos Inc., for example, CFO Tom Manley pores over "a rich array of report cards," including information about software deals. "If I had several large deals fall out of a quarter, that could create a potential material event," he says.

At the same time, some executives believe that technology can help. Even as it attempts to emerge from bankruptcy, Owens Corning will be installing a business-performance-management system in the next few years, according to former corporate finance director Kent Wegener. "Today, if we had an operating issue, it would go through several layers of management and analytical cycles before it reached the top layer of the company. But because of technology, it would be available at the same time at the top level as lower management," he says — allowing any material event to be recognized sooner. —David M. Katz

New Triggers
What the SEC says should spur an 8-K filing.

  1. An unexpected entry into a material definitive agreement
  2. An unexpected exit from a material definitive agreement
  3. Creation of a material direct financial obligation, including long- and short-term debt and capital-lease commitments, or an off-balance-sheet arrangement
  4. The acceleration or increase of a direct financial obligation or a material obligation under an off-balance-sheet arrangement
  5. Material costs incurred during an exit from a business or disposal of an asset
  6. Impairment of assets
  7. Notice of a delisting or failure to satisfy a continued listing rule or standard, transfer of listing, or completed interim review
  8. A decision that previously issued financial statements or audit reports can no longer be relied on



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