Appropriately planned taxes can enhance a company’s overall value by improving corporate earnings, strengthening the PE ratio of company shares, and influencing the way analysts perceive and cover the enterprise. Tax issues are also closely tied to risk. When companies engage in tax planning, they are interpreting laws, an activity made risky by the possibility of disagreement between the company and tax authorities. If not property controlled, tax issues can lead to a finding of material weakness by auditors. Tax planning is therefore a crucial part of risk management.

To understand the impact that tax matters may have on value and risk, boards should be familiar with five main areas: tax cash management, international taxation, tax-efficient supply chain management, transfer pricing and inbound investment.

Tax cash management
Prudent tax planning can unlock one-time or annuity cash flows trapped inside a company. Although tax is one of the largest expenses on the income statement, companies often fail to consider tax issues when trying to improve their overall cash management. This year, Ernst & Young surveyed more than 500 executives from major companies. Only one in four respondents said that their firms considered taxes when reviewing cash management practices.

One of the first things a company should consider is whether it is making the maximum appropriate use of available tax credits. For example, in an emerging area such as climate change, many firms have not yet looked into available offsets for their existing or planned investments in clean technology. Most companies know about the federal research and development (R&D) credit, but they overlook eligible expenses such as investment in plant and equipment designed minimize the environmental impact of R&D. Numerous government programs supply tax credits, deductions and abatements to companies that conduct environment “scrubs” of their business.

Many states and cities offer incentives comparable to those at the federal level, such as credits and grants for companies that provide employee training and development programs. Opportunities in this area are growing now that a number of states have launched their own economic stimulus programs.

Companies may also be able to free up cash by reviewing their transcripts and accounts at the federal, state and local levels. Many companies fail to recognize that interest and penalty miscalculations pose a serious problem for corporate taxpayers. The rules for calculating interest are highly complex, and governments may lack the resources needed to make such calculations accurately every time. If a review does reveal overpayments, these can be kept as cash or applied to another tax liability.

Reviews of transcripts and accounts typically focus on income tax, but can also include sales and use tax, property tax and state employment tax. Concerns about overpayment have led many companies to look especially hard at indirect taxes. For example, opportunities exist to review property taxes and examine whether the plant and equipment on a piece of land can be appropriately depreciated to lower a company’s tax burden.

With many states facing budget problems, state and local governments are concerned about revenue shortfalls. Legislatures have raised taxes and closed loopholes, increasing the complexity of filing returns and preventing some companies from meeting their compliance requirements. In response, some firms are considering whether to outsource the compliance function related to sales and use tax, a step that can lower costs substantially.

In addition to federal, state and local taxes, companies are seeking to manage cash flows linked to foreign taxes. Among the questions board members should be asking in this area:

• How can companies ensure that they are effectively reducing their foreign tax without triggering US tax?

• How will proposed international legislative changes affect the company, particularly its cash flow, effective tax rate and business objectives?

• Has the company taken full advantage of opportunities to access foreign tax credits, cash held offshore, or both from its international operations?

International taxation
The international arena presents companies with a distinct series of tax challenges. First, there has been a marked increase in information-sharing by global authorities. Agreements to exchange tax information between countries have existed for decades, but recently the cooperation has intensified: more countries are using the agreements, and doing so more frequently. Governments worldwide want to lower deficits and stimulate their economies, and they are looking for uncollected revenue from corporate taxpayers. Companies must prepare for increased tax controversy, assembling a defense before it is needed. All planning should be amply and contemporaneously documented, something not always done in the past but now considered a best practice.

Second, the Obama Administration is weighing plans to reform deferral of overseas income earned by US multinational corporations. It’s still unclear what shape such reform might take, but significant change is possible, with the likely result that US multinationals will pay higher taxes on income earned abroad. Certain planning approaches can secure companies’ tax position regardless of how the law may change, and more firms are investigating these approaches as a possible hedge against future uncertainty.

Supply chain management
Tough times have prompted multinational corporations to scrutinize nearly every aspect of their supply chain in an effort to lower costs. Companies are seeking ways to rationalize their supplier base, rethinking the locations where they manufacture goods, and considering whether to outsource (or insource) manufacturing and distribution.

Although greater operational efficiency can reduce costs, high taxes will erode the savings. For that reason, firms are looking to make their supply chains more tax-efficient. They are asking where their most valuable intellectual property is located, a consideration relevant even for companies that are not manufacturers. Services companies, for example, can enter into global contracts in a variety of locations.

Taking a comprehensive approach to tax-efficient supply chain management raises its own operational challenges. Companies must decide whether qualified staff will be willing to move to the chosen location, whether exit taxes will be due when facilities are relocated, and what information technology costs will be incurred in integrating disparate operations.

Transfer pricing
Used correctly, knowledge of transfer pricing can serve as a risk management tool, a means of reducing taxes and a hedge against uncertainty. Annual surveys conducted by Ernst & Young show that transfer pricing consistently tops the list of international tax issues facing multinational companies. Transfer pricing has grown more complex as regulations and audit practices have evolved, and closer collaboration among worldwide tax authorities virtually guarantees that it will continue to be a concern. Two of the main issues uncovered in our surveys relate to permanent establishments and tax controversies.

Permanent establishments are taxable presences formed (often inadvertently) when personnel or property are located in a new country where a company has not set up a formal place of business. They can stem from something as simple as having salespeople repeatedly attend trade shows or exhibit products overseas, even for brief periods. Income tax treaties may afford some protection from this risk, but often a taxable presence is created anyway. If so, the best approach usually is to admit that a taxable presence exists and establish an agreement to treat it favorably. Companies that wish to avoid creating a permanent establishment must understand thoroughly any income tax treaties relevant to its overseas business.

Tax controversies related to transfer pricing are common, and can be expected to become more so. Usually they involve two governments fighting about which one gets to tax the same dollar of corporate income. These disputes speak directly to the issue of where value is created in a company’s global supply chain. Government A might believe, for example, that a foreign-owned factory located inside its borders contributes more value than the company’s other supply chain components. Government A therefore maintains that it should get the largest share of tax remuneration. But another country may play a role in that supply chain as well, leading Government B to argue that it, too, deserves a cut. Companies caught in the middle of such disputes may be subject to double or even triple taxation, an undesirable outcome.

Techniques exist to help companies anticipate and avert tax controversies. Firms can establish an Advance Pricing Arrangement (APA), an agreement between a tax authority and a multinational enterprise that determines the appropriate transfer pricing method used for intercompany transactions. Because APAs deliver a high level of confidence in the correctness of a company’s transfer pricing methods, they can save time and reduce risk by shielding taxpayers from litigation.

APAs can be unilateral, bilateral or multilateral. Under a unilateral APA, a company may negotiate an appropriate transfer pricing method with a single tax authority for use in a single country. Bilateral or multilateral APAs are agreements between a corporate taxpayer and one or more foreign tax administrations allowing multiple governments to pre-agree that a specified amount of profit will be allocated to one jurisdiction rather than another. APAs are complex to set up in some jurisdictions, but they can be extremely helpful under the right circumstances.

Inbound investment
Today’s international business environment provides companies with unprecedented opportunities to invest in the Americas. The global trend currently involves foreign multinationals buying US corporations. This has forced US firms to become familiar with matters they may not have dealt with before, such as tax rules governing payments to a foreign parent.

Companies contemplating their first investment in the Americas, or seeking to supplement their acquisitions in the region, may find approaches that were cost-prohibitive in the past are now attractive options. Recent shifts in profitability and asset valuation, for example, may have lowered the cost of tax-effective supply chain management. By working together more closely, different parts of the organization may be able to reduce the cost of cross-border cash movements and better manage overall financial risk. Inbound acquisitions may also create tax-inefficient structures that could, in turn, present opportunities for the company to rationalize its international tax structure.

Staying on top of legislative changes
All of these issues must be viewed in the context of the rapid and broad-scale changes taking place in Washington. Board members have a responsibility to ensure that management remains up to date on legislative initiatives, particularly those involving healthcare reform and energy. The details are complex and change almost daily, but the stakes are high, so companies must spend the time needed to understand these matters adequately. In particular, boards should ensure that the corporate tax department stays current on legislative developments. One step companies can take in this direction is to require tax directors to give the audit committee quarterly briefings on any new developments. In fact, this is now considered a best practice.

Board members who stay abreast of the five tax issues outlined above will be doing their companies a service. In the process, they may also find themselves acquiring a more holistic view of the enterprise. Taxation may be the purview of accountants and attorneys, but it touches so many parts of the business that boards must pay attention to it as well.

Kate Barton is Americas vice chair of tax services at Ernst & Young, LLP.

The views expressed herein are those of the author and do not necessarily reflect the views of Ernst & Young LLP.

The report determines that the average company suffered fraud-related losses of $8.8 million over the last three years, up a mere 7 percent from the $8.2 million reported last year. The companies surveyed were categorized into 10 industries: financial services; professional services; healthcare, pharmaceuticals, and biotechnology; technology, media, and telecommunications; natural resources; retail, wholesale, and distribution; consumer goods; travel, leisure, and transportation; and construction, engineering, and infrastructure. Of the companies surveyed, 46 percent had global annual revenues in excess of $1 billion.

The sectors currently most vulnerable to fraud are financial services, manufacturing, retail/wholesale/distribution, and construction/engineering/infrastructure, all identified as industries in which poor economic performance contributes to increased fraud. Financial services, in particular, has suffered of late, with an average company loss of $15.2 million over the last three years, up from $12.9 million last year, and almost twice the average loss across all sectors.

Those sectors that were doing the least to combat fraud were professional services, technology/media/telecommunications, and retail/wholesale/distribution.

The most pressing concerns, as recorded by survey respondents, were information theft (with 20.1 percent of respondents considering themselves highly vulnerable, corruption and bribery (13.9 percent), and theft of physical assets (13.5 percent).

Kroll, a subsidiary of Marsh & LcLennan Companies, publishes its Global Fraud Report annually. To read the full report, click here.

Given these pressures—and the related risks—audit committees need to be particularly focused on the adequacy of their organization’s ethics and compliance program. Indeed, two thirds of the senior executives who took part in KPMG’s Fraud Survey 2009 identified inadequate internal controls or compliance programs at their organizations as “most enabling fraud and misconduct to occur.”

As a baseline, every organization should establish an ethics and compliance program that ensures comprehensive reporting, clear accountability, and full and effective oversight by the top decision makers. By focusing on six key elements, audit committees can help ensure that ethics and compliance programs hold up to the pressures of a turbulent business environment.

Establish the right tone at the top…and at the middle. An ethical culture, it is often said, starts with “tone at the top.” But equally important is “tone in the middle,” the influence of mid-level managers and supervisors who serve as the day-to-day role models for a majority of the organization. In addition to monitoring reports and employee survey results to get a sense of the “tone in the middle,” audit committees also should use executive sessions as an opportunity to obtain the views of internal and external auditors about the organization’s culture and tone.

Organize the business to support the program. The right organizational structure and tools must be in place to create an ethical culture that will drive an effective ethics and compliance program. This starts with a governance structure that gives the ethics and compliance program both independence and stature.

Independence is critical to guard against potential conflicts and to ensure that issues are treated objectively. And although a culture of ethics and compliance must be embedded across the organization, ensuring the independence of an ethics and compliance program may require a governance structure that separates ethics and compliance components from the operational components. Finally, a periodic ethics and compliance risk assessment is an essential part of any well-functioning governance structure of an organization.

Make the code of conduct clear and relevant. A key element of any ethics and compliance program is the code of conduct, which sets forth the organization’s core values, ethical standards, and expectations. The document should be practical, clearly demonstrating how the organization’s values apply in the everyday work environment for every person.

Maximize training opportunities. Instilling an ethical culture requires more than periodic training efforts. There are innumerable “touch points” that every organization has where it connects with its employees. Touch points can range from orientation to company-wide meetings, and from technical training to employee letters and publications.

Be prepared to respond effectively. The strength of an ethics and compliance program is measured, in large part, by how an organization responds to the reports of possible misconduct that inevitably arise. There are three fundamental elements for ensuring a successful response to ethics and compliance matters:

• Identification: Provide multiple channels of communication—including “whistle-blower’’ mechanisms that accept anonymous complaints or allegations—that enable individuals to raise ethics, fraud, and misconduct issues without fear of retaliation.

• Investigation: Ensure the consistent, fair, and thorough investigation of complaints. The audit committee should have a clear action plan in place for conducting an independent investigation.

• Remediation: For substantiated reports, ensure that appropriate disciplinary action is taken, and implement both specific and general remedial measures to mitigate the possibility of recurrence.

Re-evaluate and refine. Although it can be challenging to measure the effectiveness of an ethics and compliance program, surveys of personnel can be a good indicator of how well the program is doing. No program can be successful, however, without a process for continual re-evaluation and refinement.

Sven Erik Holmes is executive vice chair of Legal and Compliance at KPMG LLP.

With so many recent corporate crises, it is plain it’s suffice to say that a great many corporate board members and executives are experiencing similar regret right now. Perhaps this could have been avoided if they too had practiced routine diagnostic check ups. Like an individual blood test, board members need to know the risks their company is facing, and as with any health risk, they also need to be able to mitigate those exposures.

Sounds great, but the devils in the details, right? Perhaps not.

As chief consultant for governance and risk at Audit Integrity, I’ve examined the worst U.S. companies from an “integrity” standpoint in order to help board members and general auditors see how their company’s health stacks up. Audit Integrity’s metrics have shown which companies are 10 times more likely to face SEC Actions; five times more likely to face class action litigation; and four times more likely to face bankruptcy.

Using Audit Integrity’s proprietary AGR (Accounting, Governance, and Risk) score, 196 companies were identified as laggards or high-risk companies. These companies have been proven to have higher odds of SEC actions and class action litigation, loss of shareholder value, and increased odds of material financial restatement and bankruptcy. All are North American, non-financial, publicly traded companies with over $2 billion in market capitalization with an average-to-weak financial condition.

Directors should no longer accept “no worries” explanations on regulatory matters. Compliance tests should be employed routinely and if regulatory action does occur, management needs to take action.

Next, I tested the 119 metrics that Audit Integrity flags and discovered that 15 of those metrics appeared consistently as identifiers of problematic companies; the first metric was prevalent in 65 percent of the 196 high-risk companies and the 11th evident in 40 percent. The other 8,000 companies tested had low incidences of these same metrics. A list – dubbed the Risky Business Catalogue – details the common metrics within high-risk companies. Board members, the C-suite, and general auditors should note if their company is a candidate for the RBC. The evidence is not saying that significant issues are imminent if a company has one of the RBCs, but a combination of RBC metrics indicate risk factors to the entity’s business model and strategy.

RBC’s metrics include:

1. The company has entered into a merger within the last 12 months.
While there is certainly nothing wrong with corporate M&A activity, it’s common for policies to be revised and system integrations to be rushed. Company directors need to caution general auditors to be extra vigilant post merger and increase testing of balance sheet accounts.

2. The CEO and CFO’s compensation is more highly weighted toward incentive compensation than base compensation.
This situation can cause negative motivations and earnings to be increased more creatively to ensure a larger portion of executive pay packages. Close attention should be paid to revenue recognition.

3. The Board Chairman is also the CEO.
An age-old debate, but indispuditedly conflicts of interest invariably result when a company CEO is also its Chairman. Separate the roles to improve governance and reduce compromised oversight.Compromised reliability exists because the very architecture of governance has a built in conflict when the Chairman is also CEO.

4. The company has undergone a restructuring in the last 12 months.
Restructuring may be completely valid, but also can be employed to conceal the lack of sustainable earnings growth. Directors, by role definition, should be intimately involved in restructuring procedures decisions and promised outcomes.

5. The company has encountered a public regulatory action in the last 12 months.
Many corporate stakeholders hold true to the statement that where there’s smoke, there’s fire. Directors should no longer accept “no worries” explanations on regulatory matters. Compliance tests should be employed routinely and if regulatory action does occur, management needs to take action.

6. The amount of goodwill carried on the balance sheet, when compared to total assets, is high.
When intangible assets such as goodwill grow, boards should ask more probing questions about how the business model generated these assets and about concomitant valuation protocols. General Auditors should confirm that models are comprehensively back tested and impairment procedures are adhered to assiduously.

7. The ratio of the CEO’s total compensation to that of the CFO is high.
If a CEO is awarded a much larger paycheck than anyone else (particularly particularally the CFO), it increases governance risk and leads to a top-directed culture, thus limiting collaboration. Boards need to be involved in all executive compensation issues including that which drives pay packages for the CFO, Chief Risk Officer, as well as internal auditors,. etc.

8. Operating revenue is high when compared to operating expenses.
Riskier companies have revenue recognition in excess of what is expected based on operating revenues. Directors should fully understand revenue recognition policies and instruct management to test them to be sure they are not aggressive.

9. A Divestiture(s) has occurred in the last 12 months.
Data shows that riskier companies have more divestures, usually because it is an opportunity for more aggressive accounting activity. Board members should inquire as to how this action fits the strategy.

10. Debt to equity ratio is high.
When a business relies too heavily on debt it reveals that markets are not independently funding the business model or strategy. Boards should know why the markets are not investing in their entity and therefore why debt is so heavily relied upon. Board members should also be knowledgeable on the quality of their equity and not just the amount. Lastly, they should understand management’s funding overall funding strategy and the strength of contingent funding plans.

11. A repurchase of company stock has taken place in the last 12 months.
A repurchase of stock is usually presented to investors as an avenue to increase market demand for the stock, thereby elevating overall shareholder value. Management must provide reasoning for why there are no other ways to invest excess funds. Boards should also request the general auditor to review insider sales during the period of share repurchase programs.

12. Inventory valuations to total revenue is increasing.
When inventory increases in relation to revenue it should raise control questions about inventory valuation. It could indicate changing consumer preferences, which should spur an analysis of a corporation’s business model.

13. Accounts receivables to sales is increasing.
This situation can typically be indicative of relaxed credit standards. Directors should ask whether sales are decreasing due to market conditions and instruct the general auditor to probe receivables to determine their viability.

14. Asset turnover has slowed when compared to industry peers.
If assets are increasing and sales are not flowing it could indicate less productive assets are being brought, or retained, on the balance sheet. Conversely, if sales are decreasing, executives and auditors will again want to analyze changing customer preferences.

15. Assets driven by financial models make up a larger portion of balance sheet.
A collection of other accounting metrics indicates that boards, the C-suite, and general auditors should pay special attention to the controls, assumptions, and governance surrounding assets whose valuations are model driven. This is particularly true if assets that are valued by financial models make up a larger portion of the entities balance sheet.

To be sure, any one of these in isolation as an indicator of accounting and governance risk can be debated. Company divestitures and M&A can be a healthy indicator. But if a corporation fails more than a few of these metrics, board members need to take action.

It is easy to dismiss any one of these metrics when you find it is an issue in your company. Human nature is quick to retort – maybe for others but not for us. However, like time and tide, the numbers too, wait for no one. So, if you have any of these AGR metrics, you need to begin confronting these risk characteristics today to improve your corporate health and avoid the much more drastic financial equivalent of cardiovascular surgery tomorrow.

Walter Smiechewicz is chief consultant for governance and risk at Audit Integrity, a research firm that provides accounting and governance risk analysis

We’ve reprinted these questions for you in a survey format—to use as an informal benchmarking exercise—along with insights from the Roundtable discussions. At a time when expectations for effective oversight are extraordinarily high, and the business and regulatory landscapes are fundamentally changing, audit committee and board introspection is time well-spent.

How concerned are you that your board’s ability to provide effective oversight is hampered by the quality, timeliness, and credibility of the information it receives?

Very concerned ___

Concerned ___

Somewhat concerned ___

Not concerned ___

If you’re concerned, you’re in good company. Most directors want to raise the bar on information quality: They want pre-meeting materials that are clearer, more focused, and better prioritized, with more industry benchmarking and less extraneous material.

We see leading boards working closely with management to determine the critical information the board requires, including the company’s key performance indicators (KPIs) and risk information; and they’re requesting information in a format that is clear and meaningful—e.g., graphs, heat maps, or other visualizations that show how various assumptions affect forecasts (what-if scenarios), concentrations of high/low performance, and industry/competitor comparisons. They’re also seeking information from third parties (e.g., auditors, outside counsel, consultants) to test and complement the information that management provides.

To what extent does the culture of your organization encourage directors to question, challenge, and test management?

To a great extent ___

To a limited extent ___

Not at all ___

Normally, one size doesn’t fit all—but in this case, there is a best answer: “To a great extent.” To this end, leading boards and audit committees are more rigorously questioning, testing, and challenging management about the company’s key risks and management’s risk assumptions; and they’re probing management on the implications of KPIs and risk information for the company’s strategy, risks, operations, financials, and performance. As one Roundtable panelist noted, “This is not about embarrassing anyone; it’s about getting to the heart of an issue.” It’s also about fully leveraging board members as a sounding board for management: a good question could turn the direction of a discussion—or a strategy—dramatically.

Does management have a discrete, formal process that identifies the key changes affecting the business, and links that information to its risk management efforts?

Yes  ___

No  ___

Change poses risk. Boards are recognizing the importance of having a formal process to link significant changes with the company’s risk management efforts. The audit committee—which tends to have a good line of sight on these issues—can help by considering the adequacy of the company’s process for identifying significant change and linking those changes to its risk management efforts, internal control processes, and compliance program. Internal audit can help connect the dots and communicate key areas of concern about these linkages. The board and audit committee should consider whether sufficient time is devoted to looking forward—toward the risks and opportunities posed by the company’s strategy and the changing business landscape.

In which areas is your audit committee involved in helping to address the risks associated with the company’s compensation plans? (Select all that apply.)

Reviewing compensation disclosures, including CD&A ____

Defining appropriate and accurate metrics to measure performance ____

Determining quality of data used to assess actual performance ____

Ensuring compensation arrangement does not encourage “excessive” risk ____

All of the above ____

Every audit committee should, at a minimum, review compensation disclosures, including Compensation Discussion and Analysis. But the audit committee also may be able to assist the compensation committee with determining appropriate metrics to measure performance, and to assess the quality of the data used to assess actual performance. Ensuring that incentives do not encourage “excessive” risk-taking goes to the broader task of risk oversight—and here some audit committees are indeed weighing in. The bottom line: Audit committee involvement is less a question of “if,” and more a matter of “to what extent.”

Generally, in which areas are today’s boards “falling short”? (Select two.)

Leadership ____

Commitment/engagement of individual directors ____

Ability/willingness to challenge management ____

Board composition and skill sets ____

Willingness to address board performance ____

None/other ____

The highest vote-getters here were the third and fifth responses—which speaks to the increased focus by directors on board effectiveness. The changing regulatory landscape and the demands of investors, regulators, and legislators for governance reform have heightened the expectations for effective oversight. Boards are sharpening their focus on their own performance, including their ability and willingness to challenge management. For many boards, this will require shaking things up; for others, it will mean applying greater focus and intensity.

Next question: How would your fellow board members answer these questions?

“Despite some very high profile prosecutions and the pledges of rigorous enforcement by various government watchdogs, one of the country’s most troubled economic periods has created a perfect storm of increased pressures, new opportunities and dangerous rationalizations to allow business fraud and misconduct to occur,” said Richard H. Girgenti, national leader of Forensic for KPMG.

Executives’ expectations regarding changes in the incidence by type of fraud:

• Eight percent of respondents said fraudulent financial reporting would increase, while 66 percent said it would stay the same;
• One-quarter of respondents expected asset misappropriation to rise, and 60 percent said it would stay the same;
• 20 percent of those surveyed said they expected other illegal or unethical acts to rise, while 60 percent said they would remain the same.

The “volatile” mix of issues dominates the market as the turbulent economy pushes companies to make due with less resources–cutting payrolls, pushing employees to maintain output, and causing workers to do “whatever it takes” to achieve earnings goals. The government’s intense focus on illegal activity also seems to add to the pressure.

“This survey also uncovered a need for improvements in corporate programs designed to prevent, detect and respond to wrongdoing,” said Girgenti:

• The executives surveyed said improvements were needed around communication and training (67 percent), technology-driven techniques, e.g., auditing and monitoring (65 percent), and fraud risk assessments (60 percent).

• About 27 percent of respondents reported that their organizations did not fully understand how to conduct investigations, and at what point the board of directors should be alerted to potential concerns. In addition, 33 percent said they lacked protocols on how to remedy control breakdowns.

As a result of the economic crisis, it is likely that further regulatory changes will take place. “Companies that strengthen their corporate controls and compliance programs to confront fraud and misconduct risks have a better chance of prospering as the market improves,” added Girgenti.

The results of this sometimes-contentious public dialogue have far-reaching implications for corporate directors and the rest of the American business community. At the most basic level, the pronouncement issued by FASB last spring gives enhanced guidance to companies and their external auditors regarding the application of fair value, with a specific emphasis on the use of judgment. Beyond this concrete change, the fair-value debate has also created fresh questions and new public scrutiny around the role of FASB as an independent standard setter.

On the Mark?
The term “fair value” accounting, also known as “mark-to-market,” refers to the practice of using available market information to estimate the price an asset would be worth if it were sold or the cost to settle a liability. The basic principle of using market information to value at least some assets dates back over thirty years. During the last 15 years, FASB has adopted standards that have expanded and refined the application of fair-value accounting, because it has been widely viewed as an important driver of increased transparency. Put simply, applying market information to value assets and liabilities gives investors relevant information about the economic realities of the companies in which they choose to invest.

Blackstone Group Chairman Stephen Schwarzman vigorously campaigned against fair value, calling it “pro-cyclical.”

Investor demand for increased transparency has only grown over the years. The savings and loan failures of the 1980s spurred the wider application of fair-value rules. With the passage of the Sarbanes-Oxley Act of 2002, the audit committees of corporate boards were given a more prominent role in the hiring of external auditors and greater oversight of the audit process, including the application of fair-value accounting. As fair value was increasingly viewed as an important tool for improving investor access to valuable information, there was a perceived lack of a single, consistent definition for the term, or clear guidance for its application. In order to address those concerns, in 2006 FASB promulgated FAS 157. This action by FASB did not “create” fair-value accounting or somehow tighten standards; rather, FAS 157 simply established a uniform definition of what “fair value” means and provided a consistent framework for its continued application.

The introduction of FAS 157 was hardly noticed by those outside the accounting profession. In 2006, when the standard was issued, the capital markets were strong and asset holders were apparently satisfied with the prospect of marking the value of assets to the pricing information provided by markets prevailing at that time. For calendar year-end companies, the new standard would apply to financial statements for the period beginning Jan. 1, 2008, and in 2006 there was no reason to assume that 2008 would pose a problem with respect to market values. But the world was about to change.

The Fair-Value Spiral
By late 2007 and into 2008, the global credit crisis began to take hold. Asset-backed securities, particularly those tied to sub-prime mortgages, began to collapse in value as the housing market softened. Securities that had been considered relatively safe investments were suddenly revealed as highly risky. As the markets for these assets seized up, financial institutions were forced to take substantial write-downs. The write-downs reflected losses in the underlying value of assets that then led to the collapse in the market valuation of these firms, raising concerns about their ability to meet their regulatory capital requirements.
In the face of the growing crisis, the financial industry and others began seeking emergency remedies. Among the various options, attention quickly zeroed in on fair-value accounting. One of the dilemmas critics of the accounting model raised was, what happened when the market became illiquid and pricing information scarce?

In April 2008, Steve Forbes, who would become a leading fair-value opponent, published an opinion piece urging the Bush administration to temporarily suspend mark-to-market accounting. Blackstone Group Chairman Stephen Schwarzman vigorously campaigned against fair value, calling it “pro-cyclical.” Former Federal Deposit Insurance Corporation chairman William Isaac, along with former House Speaker Newt Gingrich, joined this chorus of voices calling for changes to, or suspension of, fair value. Trade associations including the American Bankers Association (ABA), the Independent Community Bankers Association (ICBA), and others stepped into the fray, arguing that fair value is not the most relevant measurement for financial instruments.

On the other side of the issue, proponents of fair value accounting, including the Council of Institutional Investors (CII), the Consumer Federation of America, and the Chartered Financial Analysts (CFA) Institute, as well as the Center for Audit Quality, issued a series of open letters and public statements arguing that fair-value accounting was not the cause of the credit crisis, nor would its suspension resolve it. Rather, these groups argued that fair-value accounting provides investors with critical transparency into the economic realities of public companies. They argued further that undue outside pressure should not be allowed to compromise the independent standard setting process.

The fair-value debate continued to intensify over the fall and into the winter of 2008-2009 as the financial crisis deepened. When Congress approved the Emergency Economic Stabilization Act, creating the Troubled Asset Relief Program (TARP) to protect the solvency of 19 of the nation’s largest financial institutions, it directed the Securities and Exchange Commission to study the issue.

In December, the SEC issued its report, which concluded that fair-value accounting had not caused the credit crisis and argued against suspending or substantially changing the standards. Rather, the report indicated that bank failures in the United States appeared to be the result of growing probable credit losses, asset quality concerns, and, in certain cases, eroding lender and investor confidence. While the SEC was clear in its judgment, the debate continued.

To help restore confidence in reporting and in the markets, the Financial Accounting Standards Board (FASB) is rushing out an unusually heavy dose of disclosure requirements. In a flurry of last-minute standard-setting activity, some new requirements were issued or have been proposed, with the expectation that the changes would be applied to calendar- year 2008 financial statements; a second round of disclosure requirements is likely to be issued and implemented this year.

For the most part, the areas targeted by the FASB for more robust disclosures are those where the related risks are neither visible nor well understood by investors, analysts, and regulators. Many of these areas—off-balance sheet entities, derivatives, and retirement plan assets—figured prominently in the news headlines as the aftershock from the large losses reported by major financial institutions reverberated through the world’s economy.

Investors want credible financial reporting, and companies want to provide meaningful data in the notes to the financial statements. Many will find the new FASB disclosure requirements both timely and helpful. But even a cursory review of the extent of the changes made last year and contemplated for this year can’t help but raise a few questions.

The most critical questions are:

• Are the expanded disclosures sufficient to restore confidence in financial reporting and address the deficiencies revealed by the financial crisis of 2008?
• Are all of the additional disclosure costs justified?
• Is the guidance sufficiently specific and standardized so that companies can follow it and investors can locate it easily?

What can be done to ensure meaningful disclosures in the future?

While a complete set of answers is elusive, a few observations seem painfully clear. First, there is little doubt that investors were caught by surprise by unforeseen risks; some major corporations were taken by surprise, too, and didn’t fully understand the extent of the risks they were taking. Second, although these are unusual times and it is understandable that new standards are being rushed out, our instincts tell us a more systematic and comprehensive approach to disclosures would be preferred in the future.

Could the financial reporting community work together to accomplish that goal? Based on our analysis of the disadvantages of piecemeal disclosures, the short answer is “Yes. We can and we should.”

There are three key drawbacks to today’s piecemeal approach to disclosure requirements:

1. Disclosures are no substitute for sound accounting. No matter how extensive, voluminous, and well-intentioned, disclosures are no substitute for good accounting principles. Increasingly, to provide flexibility in scheduling projects, the FASB appears to be using added disclosure requirements as bridges to better accounting that have not yet been agreed upon with the International Accounting Standards Board (IASB). In effect, the establishment of disclosure requirements on an ad hoc, project- by-project basis becomes a temporary measure when time is too tight to promulgate significant accounting changes and allow companies sufficient time to transition to sounder practices. This approach is sub-optimal because the disclosures become a compromise solution and the series of short-term fixes adds up to more changes than necessary.

2. No sunset process. If disclosure requirements must be established on a piecemeal basis, this process would best be accompanied by a sunset process for reevaluating disclosure requirements periodically, and removing the ones that may have been rendered unnecessary by subsequent changes in accounting requirements of related standards. Currently, the FASB does not have a process of this nature. While a full review of all disclosures could be a daunting task, there is a common theme underlying many of the disclosure requirements added in 2008 (i.e., the need for improved transparency of risks and uncertainties). Perhaps this aspect of disclosures could be singled out for special review, similar to the way the board reviewed all references to fair-value measures in connection with the issuance of FASB Statement No. 157. The goal would be to simplify the literature and combine individual requirements into general requirements wherever possible.

3. No 21st Century Disclosure Initiative. Without a periodic review of the FASB’s disclosure requirements, the United States may fall behind other countries in the move toward interactive data as described in the Securities and Exchange Commission staff report, “Toward Greater Transparency.” Prepared as part of the SEC’s 21st Century Disclosure Initiative, the report describes survey results that show many readers already find U.S. disclosure documents too long and wordy; they prefer to get their information another way, such as through a broker or financial analyst.

A more systematic and comprehensive approach to disclosures should, at a minimum, encompass the following steps:

-  Establish objectives and the purpose of disclosure. Who is the target user of the disclosures? Existing disclosure requirements seem inconsistent. Some appear to be providing context for understanding financial statements. Others appear to be patches for underlying bad accounting that the FASB hasn’t been able to fix yet. Still others appear to have become the primary source of information about a particular set of transactions.

Similar inconsistency exists with respect to the target audience. Some disclosures appear to be oriented to a reasonably educated reader, while others are more detailed and appear to be oriented to a professional securities analyst. The right audience is the reasonably educated reader of general- purpose financial statements; the additional detail that securities analysts want should be provided in statistical supplements.

-  Integrate related disclosures rather than having them appear in separate notes to the financial statements. Because disclosure requirements are established on a piecemeal basis, standard-by-standard, companies often provide each set of disclosures in a separate note to the financial statements. The FASB should seek to identify relationships among disclosures and encourage companies to integrate disclosures for related transactions, even if the requirements arose in different standards.

-  Streamline existing disclosure requirements, eliminating redundancies and excessive detail. Disclosure requirements are established on a piecemeal basis, so redundancies arise. A comprehensive approach would identify and eliminate redundancies. The level of detail among disclosure requirements also varies significantly. A comprehensive approach would identify areas of excessive (or missing) detail and conform all to a more consistent approach.

-  Consider disclosure requirements for both GAAP (generally accepted accounting practices) and IFRS (international financial reporting standards), with an objective of conforming them. The FASB and IASB have established disclosures on a standard- by-standard basis. A comprehensive review could identify strengths and weaknesses of each set of disclosure requirements and choose the better of the two.

-  Consider current GAAP and SEC requirements with an objective of conforming them and eliminating redundancies. The SEC’s disclosure requirements for Management’s Discussion and Analysis (MD&A) go beyond GAAP in some respects and duplicate GAAP in others. Some registrants duplicate large blocks of text in both MD&A and the notes to financial statements. Redundancies exist between the notes and the Business and Contingencies sections of registration statements.

Given the integration of U.S. GAAP into the SEC’s interactive data rules and the lessons learned from the current financial and economic crisis, the FASB should add a comprehensive disclosure initiative to its agenda and make it a priority.

Ben Neuhausen is national director of accounting at BDO Seidman LLP. Contact him at: bneuhausen@bdo.com.

A public company’s audit committee shares the responsibility for audit quality, through its responsibility to select, compensate, oversee, and evaluate the company’s independent auditor. Certainly, audit committees routinely obtain some information on indicators of quality from audit firms during the process of appointing or retaining their external auditors. However, the extent to which this information is actually sought and used in the appointment process for new and continuing auditors is unknown.

An October 2008 report issued by the U.S. Treasury Department’s Advisory Committee on the Auditing Profession has triggered the current debate on audit-quality indicators. The report from the committee, co-chaired by former Securities and Exchange Commission chairman Arthur Levitt and former SEC chief accountant, Don Nicolaisen, directs the Public Company Accounting Oversight Board (PCAOB)—the U.S. regulator of public company audits—to examine the feasibility of requiring audit firms to periodically report on key indicators of audit quality. The PCAOB is now considering whether a set of audit-quality indicators should be regularly disclosed by the Big Four and other firms that are auditing public companies, and if so, the specific nature of those indicators. The implication for audit committees is that in the near future, there may be available annually a standard set of audit-quality indicators on public company audit firms. This information should more fully inform audit committees as they appoint or retain their independent auditors.

As audit committees consider appointing new or retaining their incumbent independent auditors, they traditionally consider some information relevant to “audit quality” in making that decision. While the specific information used in this process likely varies by company and director preferences, standard information often considered includes the size and breadth of operations of the audit firm; the composition and experience of the engagement team; prior audit results for the audit firm and the company (if it’s a continuing audit relationship); and the firm’s planned audit approach. In a competitive audit-proposal situation, audit committee members often request additional comparative and firm-specific information. While these auditfirm characteristics are useful, they are not comprehensive in measuring audit quality.

A Framework for Evaluating Audit Quality

What is audit quality? According to the Government Accountability Office, a quality audit is one in which the audit is conducted in accordance with generally accepted auditing standards (GAAS) to provide reasonable assurance that the audited financial statements and related disclosures are (1) presented in accordance with generally accepted accounting principles (GAAP) and (2) are not materially misstated, whether due to errors or fraud.

Implicit in this definition are attributes of “inputs” to the audit (such as knowledge and independence of the audit-engagement team), “process” features (such as the appropriate type and amount of audit tests), and the appropriate “outcomes,” such as reliable financial reports and an accurate audit opinion. This suggests that audit quality is multi-dimensional, so approaches to addressing it will be as well.

The European transparency reports focus primarily on inputs to audit quality and providing information on quality controls at the audit-firm level. Such information is useful to audit committees in understanding the extent to which an individual audit firm provides resources in training and knowledge support for its personnel, and in ensuring that individual engagement teams perform audits according to professional standards. Other areas of emphasis may include concentrations or financial dependence by client size, type, or industry at the firm or geographic (i.e., office or region) level. Information on these firm-level quality indicators augments the information on the characteristics of engagement partners and other team personnel that audit firms routinely give to current or prospective clients as part of the appointment process.

Other audit-quality indicators, however, go beyond firm-level inputs and include “process” information about specific characteristics of the firm’s professional staff and the conduct of an audit. Audit-quality process indicators could include statistics on the firm’s partners, managers, and staff, and the average ratios of staff levels employed on engagements (including information on the level of supervision of junior staff). It could also include years of experience of professional staff by partner, manager and staff level; areas of expertise; relative time spent on client service, administration, training, and nonchargeable time; number of public clients per partner; audit firm personnel-retention rates by professional level; and specific types of industry-relevant training. Some U.S. audit committee members, particularly those with public accounting firm experience, report receiving such information as it relates to the engagement team assigned to their particular public company audit in the past.

While the inclusion of such specific indicators in publicly available reports is still being debated, their availability could significantly increase the information set available to audit committees on which to base their appointment or retention decisions. For instance, investors as well as audit committees could use this information to compare the extent to which competing firms ensure that audit engagements are adequately supervised by partners.

Information on audit “outputs” may also be included in the proposed periodic reports by auditing firms. For instance, output indicators could include the number of restatements or enforcement actions against the audit firm’s clients in the recent past. Also, audit firms could report on the appropriateness of “going concern” opinions—for example, rates of bankruptcy among their clients that were not given an audit opinion warning of imminent failure. Because academic research shows better financial health among audit clients of larger firms, it is particularly important that such outcome indicators be presented in comparison to a firm’s direct competitors. Other potential “output” indicators include prior reports resulting from PCAOB inspections, particularly Part II reporting (now kept confidential unless identified problems are not addressed by the firms) and reports on external quality-assurance review.

Public Reporting by Audit Firms

Some proponents of audit-quality reporting believe that audit firms should provide detailed reports on their financial condition, including how funds are invested and relative profitability. Such reporting would have two basic purposes: First, it would help regulators ensure that audit firms are sustainable. In recent decades, the number of large firms capable of auditing complex global entities has declined, and liability concerns have increased. Because losing another large firm due to financial distress could severely impact the financial markets, some regulators have expressed the need to provide oversight on the financial condition of the largest firms. A second purpose of periodic financial reporting by auditing firms is to reassure financial report preparers and users that the firm’s costs and sustainability are reasonable. Such information could also be useful to audit committees in assessing competitive proposals.

While audit-firm financial reports are public and audited in other jurisdictions such as the United Kingdom and Germany, because of the firms’ legal structure and local-company law requirements, auditing firms in the United States have resisted public reporting of detailed financial information on the basis that they are private entities.

Audits are primarily human endeavors and audit firms are very dependent upon the quality of their professionals, including competence and decision-making skills. How and to what extent audit firms invest in their personnel could also be informative in judging a firm’s commitment to audit quality. Such disclosure would demonstrate the importance placed by the firm on building and investing in human capital, technology, or infrastructure. Firms that make such investments demonstrate their commitment to the auditing profession and to corporate responsibility, rather than purely to performance and growth. While public financial reporting by audit firms was considered by the Treasury’s Advisory Committee, its final report advocates audit-firm financial reporting only to the PCAOB, which would monitor the firms for sustainability concerns.

Audit Quality Abroad

The PCAOB discussion does not exist in a vacuum, as the U.S. auditing profession had previously developed frameworks to support peer review of audit quality, while the PCAOB, since its inception, has been conducting periodic inspections of “registered” accounting firms. Also, because audit quality is a worldwide concern, other countries have been considering this issue. It is interesting to note that in the United Kingdom, which may be further along in considering the indicators of audit quality than the United States, the Institute of Chartered Accountants for England and Wales has reduced the definition of audit quality to a more principles-based approach that “at its heart is about delivering an appropriate professional opinion supported by the necessary evidence and objective judgments.”

A particularly useful framework for thinking about specific indicators of audit quality is provided by the UK’s Financial Reporting Council (www.frc.org.uk). The FRC Audit Quality Framework (summarized in chart at left) includes the following key elements that have significant effects on the level of audit quality, reflecting inputs, processes, and outcomes: (1) the characteristics of and the culture within an audit firm, (2) the skills and personal qualities of audit partners and staff, (3) the effectiveness of the audit process, (4) the reliability and usefulness of audit reports, and (5) factors outside the control of auditors that may affect audit quality.

There is also precedent in the European Union, which requires member states to ensure that auditors and audit firms that carry out statutory audits of public-interest entities publish on their websites, within three months of the end of each financial year, an annual Transparency Report. Such reporting includes a description of the audit firm’s system of quality controls.

As an example, the Transparency Reports of the largest U.K. public accounting firms identify quality-control mechanisms including: (1) the system for tracking partner and employee investments for independence purposes, (2) procedures for approval of prospective and continuing clients, and (3) standards for supervision, review, and consultation during engagements.

A “Transparency Report”

The Treasury’s Advisory Committee on the Auditing Profession report and recommendations provide a lead for audit committees in considering additional information that could be sought from their company’s external auditor or from firms placing competitive proposals. The chart (right), summarizes a variety of possible audit-quality indicators that have been discussed in the academic and practice literature. However, there are other important implications of these disclosures.

First, a U.S. “transparency report” for public company auditors would expand the set of information normally considered by audit committees, and, importantly, standardize that information and ensure its reliability through an assurance process. Thus, audit committees would have information readily available on all firms that audit public companies, prior to seeking proposals for audit services. This information could be used to provide a preliminary screen that might admit or rule out certain audit firms, without incurring the cost to the firm of preparing the proposal or to the company for evaluating it. To the extent that specific information items are required, consistency and comparability would be increased.

Second, standardizing reporting requirements would enable parties outside of audit committees such as regulators, shareholders, and potential investors to better judge how well each audit firm is managing its financial and human resources and addressing longterm sustainability concerns.

The third and likely most important outcome of such reporting is that it would also facilitate the competitive process, driving all firms to a higher level of audit quality and thereby advancing the important objectives behind the public policy of requiring audits.

For these reasons, annual transparency reporting at the audit-firm level seems an idea whose time has come. While the PCAOB’s position on this issue has not yet been released, audit committee members may in the interim explicitly request and consider these measurable audit-quality indicators. It may be that once the quality indicators become known and measurable within the context of the appointment process, audit quality (including inputs, process, and output measures) will significantly gain in importance as a differentiating factor in the independent auditorappointment process.

Ed Smith, retired partner at KPMG and former executive director of KPMG’s Audit Committee Institute, is a faculty adjunct at Boston College Carroll School of Management. Jean C. Bedard is the Timothy B. Harbert Professor at Bentley University, and Professorial Visiting Fellow at the University of New South Wales. Karla M. Johnstone is a professor at the University of Wisconsin School of Business.

The financial-services industry wants to delay an accounting rule that would force banks and others to bring some of their off-balance-sheet vehicles back into their books next year, which could force some companies to raise additional capital, reports The Wall Street Journal.

The Chamber of Commerce, the Mortgage Bankers Association, and the American Council of Life Insurers and others sent a letter on June 1 to Treasury Secretary Timothy Geithner, regarding the off-balance-sheet accounting-rule change. He believes it should be adopted “cautiously and seek to minimize any chilling effect on our frozen credit markets.”

The letter was signed by 16 industry associations, many a part of the group “Fair Value Coalition.” Some accounting experts are not surprised by the proposed delay. “Here we go again. They will get out their checkbooks and go to the Hill,” says Lynn Turner, the Securities and Exchange Commission’s former chief accountant.

The rule “includes securitization vehicles that played a large role in the bubble and allowed banks to operate with low levels of capital even though they had exposure to these assets that weren’t on the balance sheet,” says accounting analyst Robert Willens.

The financial-services industry wants to delay an accounting rule that would force banks and others to bring some of their off-balance-sheet vehicles back into their books next year, which could force some companies to raise additional capital, reports The Wall Street Journal.

The Chamber of Commerce, the Mortgage Bankers Association, and the American Council of Life Insurers and others sent a letter on June 1 to Treasury Secretary Timothy Geithner, regarding the off-balance-sheet accounting-rule change. He believes it should be adopted “cautiously and seek to minimize any chilling effect on our frozen credit markets.”

The letter was signed by 16 industry associations, many a part of the group “Fair Value Coalition.” Some accounting experts are not surprised by the proposed delay. “Here we go again. They will get out their checkbooks and go to the Hill,” says Lynn Turner, the Securities and Exchange Commission’s former chief accountant.

The rule “includes securitization vehicles that played a large role in the bubble and allowed banks to operate with low levels of capital even though they had exposure to these assets that weren’t on the balance sheet,” says accounting analyst Robert Willens.

The Boston Consulting Group and the IESE Business School of the University of Navarra in Spain predict at least 20 percent—and possibly as much as 40 percent—of the 100 largest buyout fund companies could go out of business in the next two or three years. “It all depends on investor asset allocation,” says Heino Meerkatt is a Munich-based senior partner at The Boston Consulting Group (BCG). Credit terms, integral to the private equity model are unlikely to return to the favorable conditions that fueled the last private equity boom for the foreseeable future.

What’s more, BCG and IESE, which recently published a joint, comprehensive report detailing their findings, believe many private-equity firms’ portfolio companies will default on their debts, currently estimated at $1 trillion.

As a result, more than half (54%) of private equity firms say they havewritten down the value of their portfolio companies in the last quarterwhile 57% have portfolio companies in covenant default with theirlenders, according to a recent survey conducted by the Association forCorporate Growth (ACG) and Thomson Reuters. In fact, 41% reported thatup to one quarter of their portfolio companies are in default while 14%reported one quarter to one half in default. 

So far, at least one private equity firm seems to be struggling. According to published reports, European-based Candover said earlier this year it had received offers to buy either part or all of the firm.

Like the global stock markets in general, fund-raising boomed from 2003 through 2007 for the entire private equity market, which includes leveraged buyouts, venture capital and real estate. In 2007 alone, 415 U.S. private-equity firms raised $302 billion, up 19% from $254.7 billion raised by 404 funds in 2006, according to Private Equity Analyst. The PE sponsors benefited from cheap credit, swelling asset prices, strong and growing corporate profits, and an increased willingness among institutional investors to allocate money to alternative investments in general.

However, the global economic crisis has sent all of these factors in reverse, points out the BCG/IESE report, which only analyzes buyouts. Corporate earnings as well as price-to-earnings ratios have come way down even as debt as swelled. As a result, the debt of many leveraged companies is becoming much riskier.

Standard & Poor’s recently noted that as of May 13, the number of weakest links—defined as entities rated ‘B-’ and lower with a negative outlook or ratings on CreditWatch with negative implications—surged to 293 from just 100 at the end of 2007. Of the 293 weakest links, more than half have been involved in transactions with private equity at one point or another. Most of these entities were previously rated at higher rating categories but have seen significant deterioration in recent months, S&P points out in a report. “Some of these entities were even previously rated investment grade,” the report adds.

As a result, more than half (54%) of private equity firms say they have written down the value of their portfolio companies in the last quarter while 57% have portfolio companies in covenant default with their lenders, according to a recent survey conducted by the Association for Corporate Growth (ACG) and Thomson Reuters. In fact, 41% reported that up to one quarter of their portfolio companies are in default while 14% reported one quarter to one half in default.

Of course, the general partners themselves can’t go bankrupt. However, if many portfolio companies go bankrupt, investors in a fund would wind up losing money or not get their money back, let alone make much less than they had hoped. This would impact investors’ willingness to pony up for the next PE fund in general and make it much more difficult for the sponsor to raise money for a new fund. “The moment of truth for a fund manager is the next fund raising,” warns Meerkatt.

He says the two biggest factors in determining which companies survive the shake-out is the timing of their next fundraising and their historical performance.

A PE firm seeking money now would most likely have a terrible time. For example, in the first quarter, just 78 funds worldwide raised $49 billion, down 62 percent from $129 billion raised by 203 funds during the fourth quarter and down 55 percent from the traditionally strong third quarter, according to London-based Preqin, a major industry scorekeeper. This includes buyout funds, real estate funds and venture capital funds. The first quarter total was also 70 percent less than the aggregate value of closed funds in the first quarter of 2008 and marked the lowest total in five years, the firm said.

Meanwhile, Preqin counts 1,673 private equity funds currently passing the hat around in the fundraising market, 48 more than was reported in the fourth quarter. The funds currently in the market seeking capital are targeting a total of $879.9 billion “The problem is that investors don’t have capital for even strategies investors are keen on such as distressed or mezzanine financing,” says Tim Friedman, head of publications and marketing for Preqin.

At the same time, there is a lot of dry powder. Preqin estimates there is currently $1.15 trillion in committed capital, or the total amount of capital that each fund has yet to call up. The average size of funds on the road in the first quarter was $526 million, a 5% decrease from the preceding quarter, when the average fund size stood at $556 million.

As a result, Meerkatt says historical performance will play a critical role in determining which private equity firms are able to raise money for their next fund and therefore survive. “Private equity is one of the asset classes that has stickiness of performance,” he insists. “If you are in the top quartile, it is likely the next fund will be in the top quartile.”

Meerkatt says two other factors will determine whether a firm survives the shakeout—Those that divested much more than they invested before the crisis hit and those that are heavily exposed to non-cyclical companies will fare better. “Firms that put emphasis on leverage will also have a tough time,” he adds.

Indeed, PitchBook, a private equity-focused research firm points out that these days PE funds are using more cash and less borrowed money to do deals. The typical buyout deal in the fourth quarter used 52 percent equity, way up from just 13 percent in the middle of 2007.

Will the PE market come back to life? Eventually. In the next 12 months, limited partners will have more visibility about performance and the managers will need new funds.However, much will also depend upon the hospitality of the credit markets. “Confidence is a tricky thing,” says John Gabbert, CEO and founder of PitchBook. “I’ll bet there will be more deals in the latter half, and more on the buyout side.”

In the year to date, downgrades have vastly outnumbered upgrades by almost 15 to 1. This is about 3x worse than the previous high reached in 2001, when the downgrade-to-upgrade ratio was about 5 to 1. In 2008, the ratio was 3.4 to 1, and in 2004-2007, downgrades and upgrades were about equal. The bulk of the recent corporate downgrades were in the lower rating categories, and many were ratings lowered to ‘D’ or ‘SD’ as a result of either a missed payment, a bankruptcy filing, or a distress exchange. Private equity investors are significantly exposed to these downgrades, including defaults.

The explosion of buyout activity in recent years inevitably positioned private equity investors squarely in the speculative-grade segment. In their search for yield, sponsors typically targeted troubled entities, or at the very least ones that appear to be, and many of these companies are rated speculative grade. It is in this segment that sponsors are more likely to land an entity with much potential at an attractive price and then, they hope, sell it for a profit after some sort of restructuring or reorganizing. The expertise of private equity groups to identify and rehabilitate entities, at a time when liquidity was abundant and confidence was soaring, worked very well, which, in turn, fueled the use of this model even further.

Sponsors might offer some stability to target companies with their deeppockets and knowledge and experience in managing distressed companies.In fact, some companies may have even averted bankruptcy with the helpof their sponsors. However, some practices that private equityinvestors have adopted in recent years could also have exacerbated thetargets’ balance sheets, particularly if they underestimated theseverity and duration of the current economic and financial challenges. 

However, the economic landscape has changed dramatically, and the current recession is bearing down on companies across the ratings spectrum, but is particularly harsh on entities at the lower end. Poor corporate earnings, an apprehensive consumer market, and reduced access to capital have significantly eroded credit quality. Entities rated speculative grade have less financial or operational flexibility and are therefore more vulnerable to further credit degradation.

This is evident in our ratings: speculative-grade-rated entities have not only been more volatile historically, but they also have been more likely to default. On average, during the period 1981-2008, 8.88% of entities rated ‘B-’ and 25.70% of entities rated ‘CCC/C’ defaulted within a year. This statistic even excludes entities that were downgraded to or were newly rated at the ‘B-’ and below level and that defaulted between calendar years. Although sponsors might have accounted for some of this credit erosion in their valuations, exit strategies (such as an IPO) are less feasible in the current environment, perhaps compelling sponsors to the engagement longer and deeper than they had originally planned.

The number of weakest links—defined as entities rated ‘B-’ and lower with a negative outlook or ratings on CreditWatch with negative implications—increased dramatically to 293 as of May 13, 2009, from just 100 at the end of 2007. The erosion of credit quality leads to lower ratings and more entities with negative outlooks or ratings on CreditWatch negative as well as increased vulnerability to default. Of the 293 weakest links, more than half have been involved in transactions with private equity at one point or another. The vast majority of these entities were previously rated at higher rating categories but have seen significant deterioration in recent months.

Some of these entities were even rated investment grade not too long ago. Weakest links are particularly vulnerable because they tend to have less tolerance for absorbing economic or market stress. Relative to the entire corporate speculative-grade population, it is not a surprise that weakest links would have a larger proportion of entities defaulting, particularly during periods of economic stress. In the 2001-2002 cycle, for example, more than half of the weakest links defaulted within 12 months, and nearly 65% defaulted within three years. We expect to see the same trend in the current cycle.

Corporate casualties in 2009 have already exceeded the total in full-year 2008. Similar to the pattern observed among weakest links, at least 79 of the 140 defaulters through May 28, 2009, (74 of the 126 defaulters in 2008) were involved in private equity transactions (see table 3). Sponsors might offer some stability to target companies with their deep pockets and knowledge and experience in managing distressed companies. In fact, some companies may have even averted bankruptcy with the help of their sponsors. However, some practices that private equity investors have adopted in recent years could also have exacerbated the targets’ balance sheets, particularly if they underestimated the severity and duration of the current economic and financial challenges. We forecast more than 200 defaults in the U.S. in the next 12 months, and we expect private equity exposure to these casualties to remain elevated.

Private equity groups will continue to be drawn to higher-risk assets in search of better returns.

The decline of asset valuations on the heels of the economic recession has hurt private equity investors to a certain extent. However, this may have also given sponsors a window of opportunity to further build up and diversify their portfolios. The improved risk-reward potential of some entities with sound business models makes them that much more attractive targets.

Diane Vazza is managing director, and Jacinto Torres is associate director in the New York office of Standard & Poor’s. 

]]> http://www.directorship.com/exposure-to-deteriorating-assets-increases-risks-to-private-equity/feed/ 0 http://www.directorship.com/north-of-the-border-canadas-divergent-experience/ http://www.directorship.com/north-of-the-border-canadas-divergent-experience/#comments Thu, 01 Jan 1970 00:00:00 +0000 News Editor http://www.directorship.com/?p=2438 As the recession continues to impair the movement of capital, and financial markets worldwide sit dormant, Canadian private equity suffers from a similar malaise, with buyout and venture activity at an almost dead halt. The robust flurry of asset movement within the Canadian buyout and venture capital fields that so energized the industry up to 2007 has been replaced by an uneasy standstill in which investors, entrepreneurs, and fund managers are faced with the rebuilding of the private equity marketplace.

“The impact of the financial crisis has been profound,” says Sacha Ghai of the McKinsey Group consultant/data firm. “Private equity lives off of the availability of credit, and until capital becomes available, it’s difficult for deals to go through.”

Canadian private equity, however, is at a relatively healthy point compared to its counterparts around the world, largely due to the health of Canadian banks. “[Banks] have weathered the crisis far better than they have in the United States, and there haven’t been any that have gone under,” says Ghai. “There is still capital to lend and this has to an extent muted the negative effects on the PE market.”

“The two strengths the market has is its focus on mid-market buyouts ofbetween $30 and 100 million and that buyouts aren’t leveraged asdramatically as they are in the U.S.” –Greg Smith, President, CVCA

Jacques Foisy, president and managing partner of Quebec-based private equity group Novacap, agrees. “When you come up with a good deal, the banks are still there to play,” says Foisy. “It gets more complicated with the larger deals, but overall there is still good banking support for private equity.”

Because of their stable banking network, Canadian private equity, particularly buyouts, suffered less through the crisis than the rest of the world. Canadian buyout and other PE fund managers disbursed a total of $6.7 billion to 562 deals in 2008, down 57 percent from the figures in 2007. This normally would not be perceived as good news, but compared to the losses suffered on a global scale—buyout activity dropped 71 percent from $590 billion in 2007 to just $170 billion last year—it demonstrates that Canada’s PE markets are relatively at ease.

Canadian Venture Capital & Private Equity Association (CVCA) President Greg Smith agrees that the Canadian private equity climate is healthier than some would fear. “The two strengths the market has is its focus on mid-market buyouts of between $30 and 100 million and that buyouts aren’t leveraged as dramatically as they are in the U.S.” Smith says that this more conservative approach has taught PE managers to be able to work within the confines of constrained credit conditions far better than they would be able to otherwise.

As the recession tapers off, many predict that PE will enjoy a quick recovery, largely due to the much-touted $1 trillion in unused investment capital that has accumulated in global PE fund coffers. “The money is still there,” says Foisy. “It’s just not being invested, but it will return to the market.” Moving forward, however, PE companies would be advised to look to operate differently than they did in the boom leading up to the financial crisis, says Ghai: “Investors should look to new markets and new types of investments.”

Ghai points in particular to private investment in public equity (PIPE) transactions, in which private funds look to take large stakes in public companies. “The PE firms need to bring the same virtues to public firms that they would to a private firm,” says Ghai. He also points to the opportunities provided by foreign investment groups, which made up an astounding 54 percent of Canada’s new PE commitments in 2007, and can be expected to resume such activity in the post-recession market.

Though buyouts may appear poised for a comeback, the same cannot be said for Canada’s venture capital industry, unfortunately, which suffered significantly in 2008. While $1.5 billion was disbursed to VC transactions in 2007, 2008 saw this number decline 20 percent to $1.2 billion. By comparison, VC investment in the United States suffered only marginally, dropping from $30.8 billion in 2007 to $28.2 billion in 2008. The losses, according to the McKinsey Group’s year-end findings, “[suggest] more than just a cyclical change in response to broad economic retrenchment,” and “systemic challenges.” “VC is running into a huge capital shortfall,” says Smith, who points to a meager $149 million invested in the first quarter of 2009 that suggests the climate is only worsening.

Canada’s VC field has in the past shown its value in sponsoring innovation across a number of industries. Highlights include the triumph of Research in Motion, the Ontario-based wireless developer responsible for the ubiquitous Blackberry wireless devices—a technological success only made possible through significant fundraising in the late 1990s. Canada currently has almost 1,800 companies vying for an increasingly scarce amount of funding. Returns, however, seem not to justify such investment—Canadian VC investments post 10-year returns of negative 2.8 percent, compared to 10-year returns of 16.6 percent for their U.S. counterparts. “Canadian VC is sub-scale,” says Ghai. “The funds are smaller, the capital commitments are a fraction of what you’d see in the U.S., the hold period is shorter, and it’s a pretty weak venture industry overall. This has a lot of implications, as VC is responsible for sparking innovation and industries, and it’s a bit of a millstone around the neck of Canadian innovation.”

Ghai points out that weak VC performance leads quickly to “death spiral,” in which the worse venture investments pan out, the less likely they are to earn future funding. Smith acknowledges this danger, but points to the government as a possible source of assistance. “People are recognizing that the administration has a role to play in sparking the VC market; the government needs to provide funds, and that’s what they’re starting to do.” Recently-launched government funds such as the $250 million Ontario Emerging Technologies Fund and the $825 Quebec Venture Capital Fund hope to drive start-ups in spite of the tightened investment climate and look to bring Canadian VC back to an even keel. “If the money is there to support a temporary situation, a cash-flow crisis, it’s good for start-ups,” says Foisy. “But it can’t be a long-term solution.” Indeed, Canadian VC is going to have to determine its own path to financing if it wants to continue as a proud pillar of the Canadian marketplace.

PE firms, which generally have their eyes set on many industries beyond commercial banking, of course would prefer to run thrifts with the same iron grip they use on other riskier ventures. To prevent this, the Fed limits non-bank holding companies to controlling positions of under 25 percent, which requires the type of private equity group-deal seen in the BankUnited takeover. “Banking is a fairly high-risk venture these days,” says McCoy, “and being able to control management and make investment decisions and handle risk is essential for PE firms.” However, as is often the case, the promise of profit can persuade buyout firms to adjust their expectations.

Though the credit climate is gradually thawing, capital is stillrelatively scarce, and regulators would love to see some of the $1trillion in dry powder, that global PE firms have collected inanticipation of a healthy investment climate, go into the baking sector.

“I’m not sure [PE firms] need control of the banks,” says Lawrence D. Kaplan, general counsel at Paul Hastings and a former regulator with the Federal Home Loan Bank Board (now the Office of Thrift Supervision [OTS]). “I think most firms view the banking sector as underpriced, and financial institutions now have terrific opportunities to get returns for investors.”

The introduction of PE firms into the banking sector is also advantageous for regulators eager to get commercial banks back on track. Though the credit climate is gradually thawing, capital is still relatively scarce, and regulators would love to see some of the $1 trillion in dry powder that global PE firms have collected in anticipation of a healthy investment climate. Says Walter J. Mix III, managing director of consulting firm LECG, “The size of the banking and savings and loan problem exceeds the FDIC funds’ capacity, and the banking sector will need private as well as government capital in order to improve credit availability.”

In order for that money to make its way through the thousands of U.S. commercial lenders, regulators are going to have to come to an agreement on just how PE firms interact with small banks. “The issue for the regulators is that they want a well-qualified board of directors and management with the requisite banking experience,” says Mix. “In this type of market, that especially means experience with credit and liquidity.” While the Fed has so far taken a hardline stance, the OTS has proven itself more willing to allow leeway among the approximately 800 thrifts it regulates. Earlier in the year, the OTS approved the takeover of thrift Flagstar Bancorp by distressed assets specialist MatlinPatterson Global Advisers. For $350 million, MatlinPatterson got a 70 percent stake in the Troy, Michigan bank, going against the Fed’s opposition to PE firms taking majority stakes.

The FDIC, too, has shown its willingness to cooperate with private money. Says Kaplan, “We may see a willingness of the FDIC to allow private equity buyout deals, and if this happens, it’s going to put pressure on the Fed to hammer out a deal with other regulators to determine when such buyout deals would qualify as sound.” Besides the BankUnited deal, the FDIC approved the sale of $13.9 billion worth of IndyMac assets to a group of private equity investors that included J.C. Flowers and Paulson & Co. Following the close of the BankUnited deal, the regulator pointed to an upcoming policy shift: “Due to the interest of private equity firms in the purchase of depository institutions in receivership, the FDIC has been evaluating the appropriate terms for such investments. In the near future, the FDIC will provide generally applicable policy guidance on eligibility and other terms and conditions for such investments to guide potential investors.”

Clearly, the tide is shifting in favor of more and more private equity firms that want a stake in the banking sector. With trillions in banking assets on its books, the Fed may need to reevaluate the merits of PE buyouts as apply to the heretofore sacrosanct area of commercial banking. Says Kaplan, “The Fed’s going to have to look at potential buyouts on a case-by-case basis, and to look through the legal precedents, but they can’t ignore that PE has the cash and because of that we can’t rule them out.” Mix says that it’s possible for private equity to make a bigger footprint in the banking industry without a complete overhaul of the rules: “I wouldn’t foresee a policy change unless Obama or Congress specifically directs such a change. Regulators are going to try and make it work with the tools they have.”

The lawsuit, filed late Friday in Orange County Superior Court in California, said Emulex shareholders should be wary of Broadcom’s efforts to acquire the company because of the scandals that have engulfed Broadcom in recent years.

Lawsuits are a common tactic in hostile takeovers as each side seeks to gain leverage over the other.

“It is material for stockholders and employees of Emulex to understand that they are not dealing with an honest enterprise,” the lawsuit alleges.

The suit asks for an injunction against Broadcom to “prevent fraud and irreparable injury” that would result from being taken over by a company it claims hasn’t disclosed everything about its troubled past.

In a statement, a Broadcom spokesman said “none of the historical claims in this suit is relevant,” to the company’s $9.25 all-cash bid for Emulex. “Emulex shareholders deserve better than mudslinging and scorched-earth tactics designed to block shareholders from their ability to accept our offer,” the spokesman added.

The lawsuit is a bitter turn in the months-long battle between the two California technology companies. Emulex, which makes networking tech used to connect servers and equipment in company data centers, has said Broadcom’s offer is too low.

While prior studies have focused on whole company, going-private buyouts, our sample includes transactions with minority stakes, syndicate deals, and consolidating roll-up or add-on strategies, and we have detailed information on internal rates of return, leverage, equity stakes, and other deal characteristics.

We find that the pursuit of ancillary consolidating acquisitions is the biggest driver of post-buyout revenue and profit growth, that solo deals and deals with controlling stakes outperform syndicated or “club” deals, that rates of return have declined over time as buyout markets have become more competitive, that mitigation of agency costs is critical for deal success, and more generally, that private equity can improve the performance even of sound businesses by providing access to resources, industry-specific expertise, capital for recombining assets (most often, consolidation in a fragmented industry), or recapitalization and ownership transition.

Mid-Size
Our focus is on small and mid-sized deals. This end of the buyout market features not only the investment goals found in larger public-company buyouts, which include cost elimination via consolidation and exploitation of scale and scope economies, but also a variety of strategies aimed at improved management coordination and control. The range of transaction rationales seen in smaller and middle-market buyouts forces PE investors to take on several roles including banker, operating executive, board member, strategist, headhunter, coach, union negotiator, and occasionally family therapist. There is thus perhaps a “fuller” view available here with respect to the manner by which PE professionals seek to create value in their deal-making.

Focusing on middle-market transactions highlights some interesting characteristics of the PE world that are hidden in studies of larger deals. Most prior work distinguishes between two types of buyouts: restructuring deals designed to mitigate agency costs in mature, low-growth, low-beta industries; and growth-equity transactions based on investments in high-growth industries. There is a third category as well, however, an intermediate type we might call coordination-improving deals. These typically involve sound businesses that can nonetheless benefit from PE firm ownership bringing access to resources, industry-specific expertise, capital for recombining assets (most often, consolidation in a fragmented industry), or recapitalization and ownership transition. The intended result in these transactions is better coordination of deployment of a firm’s assets, often in recombination with market-based resources. These kinds of transactions occur often in our sample, and would appear to manifest a major benefit of—and under-reported storyline about—private equity governance.

Conclusions
More generally, our preliminary analysis of this sample of middle-market transactions suggests that, fundamentally, growth is the ultimate driver of wealth creation for smaller companies. Over three quarters of our sample experienced increases in revenues and operating profits, and, not surprisingly, those transactions with the highest revenue and profit growth rates have the highest rates of return. The same applies to increases in employment. For these deals, PE was a catalyst for exploiting scale and scope economies and providing operating leverage.  

Second, for this sample, return on equity for PE transactions is negatively (and significantly) correlated with exit year, suggesting a secular decline in returns (and, the increasing competitiveness of the PE industry), even for the lower middle-market arena for  small-cap transactions. This can be seen as part of the relentless Schumpeterian efficiency wrought from dynamic, innovative, and competitive markets.

Third, insights from agency theory (Jensen 1986, 1988) and transaction cost economics (Williamson 1988, 1996) are substantiated in our sample transactions. The low-tech, slow-growth consumer-goods manufacturers have the highest-return transactions, highest average leverage, highest average levels of management equity and PE firm equity, and most of the controlling-stakes deals. More broadly, the slow-growth manufacturing businesses are more heavily leveraged and exhibit better returns than marketing and services businesses. Marketing and professional services firms have less average leverage, more syndicate club deals, more minority-stakes deals, and exhibit higher revenue and profit growth (and, more organic growth deals than those involving add-on acquisitions). IPOs have the highest returns as an exit type, followed in order by exit types characterized by progressively more knowledgeable buyers. These straight-line differences in results across exit types apply as well to leverage, holding time, revenue, profit and employment growth, capital expenditure growth, and management equity.

Fourth, controlling-stakes and solo deals are characterized by twice the return, one-third to one-fourth the size, shorter holding times, much higher leverage, and lower debt pay-down ratios than their counterparts. They are also far more heavily concentrated in slow-growth manufacturing industries. This is not to deny the growing importance of syndication in private equity. However, our data clearly show the long-term performance advantages of control transactions focused on low-beta industries that are amenable to leverage (and, the ability of the majority or sole owner to bring about a new, more focused, strategy).

In our sample, the pursuit of ancillary consolidating acquisitions is the single most important determinant of transaction IRR for equity. This shows the extent of available “slack” in fragmented industries ripe for exploitation by small- and mid-cap PE investors. Additionally, leverage affects equity IRRs positively and asset (or total firm) returns negatively, consistent with received theory. For improvements in operating performance, the presence of an add-on transaction and the amount of leverage are key to explaining revenue growth, and leverage is the main driver of growth in EBITDA. That is to say, the fastest-growing firms are burdened with the least amount of debt.

John L. Chapman, PhD is the NRI Fellow in Economics at the American Enterprise Institute. Peter G. Klein is Associate Professor in the Division of Applied SocialSciences at the University ofMissouri. The full paper can be downloaded from the CORI Working Paper Series Index.

While it is the responsibility of management to maintain these alignments, audit committees—particularly given their role in the oversight of financial reporting,internal controls, and compliance—are in a unique position to oversee management’s efforts. The audit committee has a good line of sight over many of the critical activities that must be aligned.

The fundamental challenge for audit committees is to help ensure that management has in place the necessary processes for proper linkage between the array of activities that must be aligned (and realigned) as significant changes occur and risks develop. That challenge can be made more difficult by the scope and magnitude of the changes impacting the business, as well as the risks these changes pose. To address this challenge, we suggest four questions for audit committees to consider.

• Does management have a formal process to identify the significant changes—planned and unplanned—taking place in the business, and the important risks these changes pose? Change—whether a change in people, business processes, technology, products, or business models—creates risk. And an important part of any discussion about change and risk is “complexity:” the greater the complexity,the greater the risk. While a robust change management process to identify and track macro- and micro-level changes impacting the business may be ideal, every company should, at a minimum, consider the need for a formal process to identify the significant changes—planned and unplanned—taking place in the business and the risks that these changes pose.
• Is there a formal process to link these changes and risks to the company’s risk management efforts, its internal control processes, and its compliance program?All changes pose risk. For example, outsourcing changes pose an array of data security and privacy risks; changes in business processes and practices pose various internal-control issues; and changes in the company’s footprint may pose a host of Foreign Corrupt Practices Act and other compliance risks. Whatever the change, it is essential that it and the associated risks are communicated so that appropriate risk-mitigation activities, internal controls, and compliance initiatives can be implemented. A formal process to ensure that this communication takes place and that proper linkages are established is key.
• Does internal audit “connect the dots” and communicate key areas of concern about these linkages? As the role of internal audit evolves, more organizations look to the internal audit function to observe where change and risk are first seeded in the organization, and to view how these changes and risks are managed across the organization.This requires that internal audit has a “seat at the table,” is capable of anticipating emerging risks, and that it takes the initiative to adjust audit plans and activities as changes in the business, the control environment,and the economic environment occur.
• Given the speed of change—and the velocity of risk—does management assess the company’s critical alignments on a regular and frequent basis? The economic crisis demonstrates clearly that changes are often fast and dramatic, and that there is a real need for management and directors to understand the velocity of risk—the speed at which an emerging risk can be manifested and have a catastrophic impact on the business. In this environment, management should assess the company’s critical alignments on a regular,frequent basis; annual or semi-annual assessments may not be adequate.Of course, the absolutely essential component of alignment is management. And here the audit committee and thefull board play a key role in helping to ensure that—from top to bottom—management’s goals, objectives, and incentives are properly aligned, that performance is rigorously monitored and assessed, and that the culture throughout the organization is “right.”

Mary Pat McCarthy is vice chair, KPMG LLP (U.S.), and executive director of KPMG’s Audit Committee Institute, and Michael J. Nolan is global partner in charge, internal audit, Risk and Compliance Services at KPMG LLP.