It’s the last week of the calendar year, and much of the accounting world is abuzz. Corporate accountants are putting the final touches on the those revenue accrual entries that will ensure that their company’s earnings will meet analyst expectations.  Global accounting firm auditors are completing audit “hand waving” exercises to justify their client’s optimistic balance sheet valuations and earnings increases.  And accounting standard-setters continue to avoid meaningful solutions to significant reporting problems including revenue recognition, lease accounting, and goodwill valuation, just to name a few.  What do grumpy old accountants do you ask?  This one tilts at windmills… 

It’s only been three months since I expressed displeasure with recent hype about what characterizes great CFOs today (see “Ten Commandments” for Today’s CFO), and nine months since I ranted about innovative performance metrics that were anything but (see “Innovative Performance Metric or Marketing Spin?”  Well, the business press is at it again with an article in the Wall Street Journal (WSJ) CFO Journal titled “ModCloth CFO: Four Metrics That Mean More Than Money,” penned by Jeff Shotts, ModCloth’s CFO.  The “innovative” measures this time are engagement, relevant user generated content (UCG), underserved market signals, and the ratio of rules broken to rules followed.  These four non-financial measures purportedly “power a high return on investment,” but instead are quite superficial, ill-defined, and clearly qualify as MBA speak.  What’s my beef this time?  ModCloth’s CFO fails my transparency standard (Commandment No. 6) , and is close to violating my “real” performance measurement criteria (Commandment No. 7).  Also, as someone who has clearly crossed the threshold of geezerdom, I have no patience for those selling something as “new and innovative,” when it is not.  Not a good start at all at being a great CFO!  So, let’s dig in…

My biggest disappointment in this article is the CFOs suggestion that some performance metrics “can be” more important than others.  This completely ignores the basic principles outlined in the widely-used, and time tested Balanced Scorecard planning and management system.  Performance metrics are supposed to provide evaluation data on different aspects of an organization’s operations (financial, customer, process, and learning and growth).  So, if you decide to measure something, presumably this dimension is important in its own right.  

It also is interesting that the four key metrics touted are all non-financial in nature.  I am not surprised at all that financial measures are ignored by the ModCloth CFO. Since ModCloth is still a young, private company, presumably focused on growth, the financial metrics are likely not very flattering (i.e., operating losses, negative cash flows, etc.).  In fact, I bet the Company’s senior leaders and investors regularly shrug off the financial metrics as not being representative of the great things happening in the organization.  Could “adjusted EBITDA” be far behind?  

But what about measures that provide insight into how ModCloth’s business model is performing ?  Only one of the four non-financial metrics (i.e., UGC) appears to directly relate to even one of the Company’s five value chain activities.  And then there’s learning and growth?  How are ModCloth’s investments in its people and technology performing?  How are these being evaluated?  But enough on what was NOT discussed in this article. Let’s take a closer look at the customer-based measures about which ModCloth’s CFO is so passionate.


ModCloth’s CFO defines engagement as user actions that have been proven to increase the average lifetime value of a customer and drive powerful solutions to otherwise intractable business problems. He concludes that:

The more engaged your customers are, the more value your business can create and the more flexibility your business will have to solve problems in a unique and differentiated way.

What an insight!  Customer relationships matter and longer, more engaged customers are particularly valuable…I am simply stunned that this is something that should be measured…NOT!  Don’t most retail businesses routinely recognize this through their use of loyalty programs, discounts for multiple service subscriptions, and the like?  

What troubles me most about this so called metric is how this CFO measures engagement. His threshold for achieving engagement is quite low, as simply signifying that you “like,” “love,” “share,” “review,” or “endorse” constitutes engagement.  Sorry, without an actual sales transaction, I would argue that he is really capturing technology usage, or interest…not consumer engagement. Yes, hopefully this consumer interest will ultimately lead to a purchase transaction, but ultimately it’s a sale that confirms engagement.  At best, this “interest metric” is a leading indicator.  However, this grumpy old accountant understands why this CFO measures customer engagement this way particularly in an online environment…absent actual sales, his engagement (and growth) numbers are going to look much better than the sales numbers. And this is likely going to be a big deal as ModCloth plans its inevitable IPO. Imagine if “brick and mortar” retail companies measured and reported customer traffic through their outlets as engagement…I am quite sure those numbers would dwarf retail sales.

User Generated Content (UGC)

The MBA-speak term UGC refers to nothing more than after-sale customer feedback that the Company captures and uses to improve the sale and marketing of its products. Again, after-sale customer feedback has been a key business model component for decades, so there is nothing new here.  Should I be troubled that ModCloth’s CFO thinks this is something to write home about?  Could there be other business model components that this on-line Company is missing or not addressing adequately?

 Signals from Underserved Markets

This purported metric is NOT a measure, but rather data collected from a number of “tried and true,” traditional, customer-focused performance evaluation tools.  And once again, ModCloth’s CFO serves up yet another marketing gem:

If you have direct connections with your customers and listen well, they will tell you when you have the potential for a break-through offering in the market.

Imagine…listening to your customers and observing their behavior pays off!  Who would have thought?  And what media does this CFO use to collect this consumer data…nothing that we haven’t been using for decades: surveys and interviews.  And of course, being an online retailer, there’s also the data gleaned from the aforementioned customer product reviews (i.e., engagement), and Facebook posts.  Particularly surprising is that this CFO admits to learning the value of customer feedback from his eBay experiences, rather than his MBA program…hmmmnn.

Ratio of Rules Broken to Rules Followed

ModCloth’s CFO concludes his article, not with an actual performance metric (as promised), but with encouragement to “break the rules.”  There is no discussion of which rules should be broken or which rules should be followed, which can be quite dangerous if he is “selling” his ideas to the uneducated and/or inexperienced entrepreneur.  Not surprisingly, he provides no benchmark level for this metric either.  His “ratio” is nothing more than encouragement to innovate by questioning the status quo and generating ideas on process improvement.  As with his other three non-financial metrics, this “new” advice on innovation has been in the marketplace for quite a while.  Maybe he should check out “Every Manager Can Be an Innovator” for some ideas on how to extend innovation throughout his Company’s business model.

Hopefully, you now share my grumpiness about this “fluffy” article, and are now asking how and why this CFO ever was allowed to publish this piece in what many consider to be a well respected, and reputable media outlet.  Well, you don’t have to search far for the answer…simply google “MedCloth and Deloitte,” and the answer will be clear.  You will find that MedCloth’s reporting manager came from Deloitte, as did one of the Company’s senior accountants.  Additionally, a Deloitte partner Tim de Kay acknowledges providing client services to ModCloth on his LinkedIn page.  So what,  you ask?  Well, Deloitte pays the WSJ to publish such articles. 

So, given the superficial nature of this ModCloth CFO article, this grumpy old accountant must conclude that it was nothing more than a shameful exercise in hyping a future Deloitte technology IPO client.  Doesn’t this call into question pretty much everything published in the WSJ’s CFO Journal?  Now I have to view all WSJ articles with greater skepticism (if that’s possible) to decide if they are really news, or just marketing promotions (as apparently this one was).  And, if it wasn’t bad enough that Deloitte has recently damaged the credibility of audits, now the firm is contributing to pseudo-journalism thus further hurting society.  There has to be a New Year’s resolution in here somewhere, right?

This essay reflects the opinion of the author and not necessarily that of The American College, or Villanova University.

AuthorAnthony Catanach

For those of you that may have thought that my grumpiness may have been tempered a bit by the advent of the holiday season…Bah Humbug!  There is just so much accounting and financial reporting nonsense out there this quarter, that I have been simply overwhelmed by stuffing stockings with lumps of coal for my favorite global accounting firm (GAF) partners, and the humbug large bank clients they serve.

Let’s begin with Jonathan Weil’s recent discussion of Morgan Stanley’s “immaterial” $9.2 billion correction of an operating cash flow (OCF) classification error.  The problem?  Morgan Stanley (MS) accountants didn’t formally restate the Company’s financial reports for the error as required, instead opting for the sleazier “stealth restatement” route on the basis of immateriality.  Where were the auditors?  Well, the auditors actually appear to have discovered this error…my heart be still.  But MS has been “audited” by Deloitte (of recent PCAOB fame) since 1997 according to Audit Analytics.  Why should I be surprised that a GAF auditor actually found something, then looked the other way?  

AuthorAnthony Catanach

Several years ago, the Grumpies were pretty hard on the agencies tasked with enforcing audit quality and ethical accounting behavior in the United States (see Paper Tigers: The U.S. Accounting Oversight Regime).  But my how times have changed…the “Paper Tiger” has become “Tony the Tiger,” and that is just grrrrreat!  What am I talking about?  Well, it has been a really bad month for the global accounting firms (GAFS).  

AuthorAnthony Catanach

When we think about the worst U.S. accounting scandals ever, those new to the profession usually cite the Lehman collapse or Madoff scam of 2008,  or maybe even the Enron tragedy in 2001 which has become symbolic for bad accounting and auditing.  And those of us with gray (or no hair) might recall the ZZZZ Best, Crazy Eddie, or Equity Funding debacles.  However, many of us may have missed what may be the largest and longest running accounting swindle ever, one that finds accountants scamming accountants.

AuthorAnthony Catanach

With yields on fixed income securities at or near historical lows, today’s retirees and those planning for retirement are facing major challenges.  Not surprisingly, many individual investors as well as pension funds increasingly are turning to high-yield bonds and bond funds to meet their income requirements. So what’s the problem?  An increasing number of bond funds, pension managers, and other institutional investors are loading up their portfolios with an untested and unproven product about whose long-term performance we know very little:  the event-linked security or catastrophe bond (CAT bond).

AuthorAnthony Catanach

I love Twitter!  Why you ask?  It allows me to easily discover and distribute content…that’s why!  But as Twitter continues its march to a November 15th offering date, there’s a storm brewing that just might end this love affair.  The Company’s recent filing raises a whole new series of questions about its strategy, business model, AND accounting that probably won’t get answered before its initial public offering (IPO).  There just isn’t enough time left for capital market regulators to force answers (thanks to the JOBS Act), nor is management likely motivated toward transparency given the nature of the issues. 

AuthorAnthony Catanach

Recently, we learned that Twitter had begun its initial public offering (IPO) process using the streamlined regulatory framework introduced by the 2012 Jumpstart Our Business Startups (JOBS) Act.  And as analysts and investors search for clues on Twitter’s valuation, many again are raising questions about how the JOBS Act impacts financial reporting transparency.  In questioning the Company’s recent JOBS Act filing, Holman Jenkins of the Wall Street Journal asked:

Why does a super-prominent company like Twitter need to avail itself of these arrangements?

 Great question!  As many of you know already, this grumpy old accountant has never been a fan of the JOBS Act (see “Garbage In, Garbage Out - Are Accountants Really to Blame?” and “Is Model N A Transparency Violation?”).  Any legislation that reduces the ability of market participants to make informed investing decisions, gets a “no” vote from me.  But in this case, what WILL Twitter’s financials really tell us?  Nothing that we don’t already know!   Let me explain…

We should not be surprised by Twitter’s JOBS Act filing.  There are already hints that the 2010 and 2011 numbers were not good, so why not postpone public disclosure as long as possible.  As for current numbers, not much is publicly available, but market-research firm eMarketer reported advertising revenues for the Company of $288.3 million in 2012, and expects $582.8 million in 2013 and $950 million in 2014.  All of this makes valuation a bit problematic, forcing reliance on recent private transactions which some believe may justify a $9 to $10 billion value.  From this one might incorrectly conclude that the Twitter IPO could be a “poster child” for what it is wrong with JOBS Act disclosure.  But we don’t really need current financial statements from Twitter!  We already have everything we need to form a pretty good idea what the post-IPO balance sheet, income statement, and statement of cash flows will look like.

All we have to do is apply the basics of market multiples analysis to create a set of financial statements for Twitter.  If we agree that similar companies have similar assets and capital structures, then we should be able to “back in” to Twitter’s post-IPO balance sheet.  But first we must find a set of “comparable” (comp) companies.  This comp group should share commonalities in industry, technology, customers, size, capital structure, and growth prospects, to the greatest extent possible. 

I used the Global X Social Media Index ETF as a starting point in finding my Twitter comps.  This yielded 27 companies which I narrowed down to 19, as 8 were listed on foreign exchanges which precluded easy data access.  Next, I eliminated companies that did not appear to have a business strategy or model similar to that of Twitter.  For example, I retained all companies with Standard Industrial Classification (SIC) codes 7320 (i.e., computer programming, data processing, etc.) but deleted those with SIC codes 7371 and 7372 (i.e., computer programming services and prepackaged software). Companies like, Zynga, and Jive Software fell out as comps.  Finally, I deleted companies whose primary revenue source was NOT advertising.  This eliminated Nutrisystem, Pandora, Groupon, United Online, Youku, Google, Netease Inc., Yandex, Angie’s List, LinkedIn, Demand Media, and Renren.  This yielded a final comp group consisting of Facebook, Sina Corp, Yelp Inc., and Meetme Inc. 

After selecting comps, I used fiscal year-end 2012 balance sheet data from Wharton Research Data Services to create common-sized balance sheets for each company.  Then, I averaged each balance sheet line item for each asset category.  With this data I then forecasted a post-IPO balance sheet for Twitter.  This yielded a balance sheet comprised of the following major asset categories (and percentage amounts): cash and short term investments (41.84 percent), other current assets (11.83 percent), Net PPE (8.36 percent), and goodwill and other intangibles (28.36 percent). Given the relative recency of these comp company IPOs, Twitter’s hypothetical capital structure is dominated by a stockholders’ equity of 81.16 percent, with current and long-term liabilities totaling only 10.93 percent and 7.92 percent, respectively.

Next, I estimated Twitter’s total assets relying on recent annual revenue amounts reported in the popular press ($600 million), and the average revenue to assets percentage (46.84%) of my four company comp group. This generated a total Twitter post-IPO asset base of almost $1.3 billion. Finally, to get amounts for each balance sheet line item, I simply multiplied the $1.3 billion in total assets by the above balance sheet category percentages for my comp group.  And voila, a post-IPO balance sheet for Twitter!

 Now, does the balance sheet make sense?  Sure and here’s why.  The significant cash balances reflect the recapitalization proceeds from the IPO.  The large amounts of goodwill and other intangibles are the result of numerous company acquisitions made during the past two years according to Victor Luckerson: Vine (October 2012), We Are Hunted (Fall 2012), Bluefin Labs (February 2013), Ubalo (May 2013), Marakana and Trendrr (August 2013), and MoPub (September 2013).  There is no surprise here and some of you may recall the grumpies ranting about intangibles and cost capitalization issues last year in “The Beauty of Internet Company Accounting.”  In that same post, we also explored valuation concerns about deferred tax assets.  As noted above, Twitter’s balance sheet undoubtedly will include these intangibles as well, probably a function of the sizeable tax net operating losses that the Company is now compiling.  

And what about the income statement you ask?  Well, since advertising seems to be the major revenue source in this version of the Company’s business model, it is unlikely that we will see any of the unusual sales treatments found in the recent IPO’s for Groupon (i.e., gross vs. net), Linked In (i.e., multiple deliverables), or Zynga (i.e., virtual goods).  

There is generally nothing very complicated or interesting about advertising revenue recognition.  However, three of the four comps (Facebook being the exception) reported operating losses after depreciation and amortization for fiscal year 2012 which is understandable given the start-up nature of these ventures. Twitter no doubt will report operating losses as well, and can be expected to make liberal use of non-GAAP metrics to “explain away” poor performance as not reflective of “reality.”  It will be interesting to see what expenses the Company deems “special” or “non-operating” in nature: depreciation, amortization, stock-based compensation, acquisition costs?  All of the above?

Then, there are the operating cash flows (OCF).  The same three comps (Sina, Yelp, and Meetme) reported either negative or transitory OCFs for 2012, clearly reflective of their stage in their company life cycle.  We should expect more of the same from Twitter.  For those of you that think I am being overly harsh toward social media IPOs, remember that Facebook earned an “A” in financial reporting from the grumpies.

So, see…we really don’t need those financial statements after all, do we?  But in “Please Twitter, Just Stay Weird,” Fahad Manjoo raises a number of strategic concerns which this grumpy Twitter user wants answered, and soon! For example, once a public company, Twitter will be forced to run more ads.  We already see this coming as the Company “Strikes Deal with the NFL” and “Pitches Itself to TV Networks.”  How will monetization ultimately affect the user experience?  And then there is the continuing social media company dilemma…who is the customer?  The media user who pays little or nothing, or the advertiser who is so key in revenue creation?

Taking care of the advertiser might actually chase off users.  As the Wall Street Journal’s Yoree Koh and Keach Hagey indicate:

Getting companies to pay for Twitter publicity is a crucial distinction for the seven-year-old company as it tries to convert its online influence into a business model—especially when rival Facebook Inc. also wants to become a hub for real-time conversations.


If Twitter simply “devolves” into another Facebook News Feed, one could argue that the Company may be sacrificing the very identity that made it special in the first place.  

And the concerns/questions don’t stop there.  Why all the sudden pre-IPO buzz on NFL contracts, new ad products, and new acquisitions?  How do all these tie into the Company’s strategy, or do they? Why the sudden pre-IPO need for working capital?  Is there some sense of urgency to look like a real company?  Or could this just be another Grouponesque scenario designed to enrich a select few by bringing to market a neat idea and platform with no real proven way to make money with it.  Few would disagree that Groupon’s initial premise was exciting…using technology to bring merchants and customers together. However, initially the company had no real strategy, model, or sense of market competition, all of which has contributed to its recent operating struggles.  And it doesn’t help that Twitter turned to a former Zynga player to lead it to market, or that it just now is looking for a financial reporting manager. Just some of the concerns running through this Twitter loving grumpy old accountant’s head.

I vehemently disagree with Wharton Professor Lawrence G. Hrebiniak who indicated that:

[Twitter] must release its data at least 21 days before marketing the IPO, which, in today’s highspeed cyber world, is more than sufficient for investors and others to examine and evaluate the company.

Twenty-one days may be enough to push some numbers around in a spreadsheet, but it is clearly inadequate to promote a meaningful dialogue with management to address the unanswered questions about strategy and business model and leadership.  Yet, people are still going to buy into the Twitter IPO, just like they did for Groupon and Zynga.  Hopefully, the outcome will be more positive.  If not, Twitter’s 140 character limit should be sufficient for the eulogy…

This essay reflects the opinion of the author and not necessarily that of The American College, or Villanova University.

AuthorAnthony Catanach
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I’m really getting tired of hearing about the changing role of today’s Chief Financial Officer (CFO), particularly all of the consulting hype about the “need to be strategic.” Good CFO's have always been strategic!  This recent barrage about the advent of the strategic CFO is simply 21st century spin that masks a major human resource dilemma at today’s global companies: the wrong individual is in the CFO seat.  And then there’s the compulsive need to anoint the “Best CFO.”  Yes, we live in a rankings crazed society, but those who feel compelled to create such a list simply don’t know anything about business, much less what CFO’s do, or are supposed to do.  All of this has prompted this former CFO to share my “Ten Commandments” so that readers can judge for themselves who the top CFO’s just might be.  But first, some context is in order.

The “Pragmatic Strategist”

A recent blatant sales pitch in the CFO Journal titled “The CFO as Pragmatic Strategist: Lessons from the Lab,” really made this Grumpy Old Accountant’s blood boil.  This superficial piece resurrects an old theme, and repackages it as something new, this time as coming from the “lab.”  But as my colleague Noah Barsky and I pointed out in “What Makes a CFO ‘the Best’?”, there already exists a rich reading list going back a decade, which offers meaningful insights into the skills needed by a CFO.  And not surprisingly, one of these is a strategic mindset.  It also really bothers me that this article attempts to cloak a consulting exercise in the robes of scientific inquiry by suggesting that its rather obvious finding came from a “lab.”  So, exactly what did the “lab” yield? The big takeaway was a seven question CFO guide to value creation that targeted two main areas: does the CFO know the company’s strategy and the related risks to executing it?  Duh…

In an attempt to reign in my cynicism about this article, I did find one potentially worthwhile nugget.  Maybe the “lab” stumbled on to a serious problem in the C-suite.  Presumably the lab assistants evaluated a large sample of CFO’s.  If so, their finding that CFO’s need to “cultivate” a strategic mindset suggests that currently many CFO positions are being filled by unqualified individuals!  That just might explain the rash of disappointing IPO’s, accounting restatements, internal control weaknesses, and frauds that continue to plague global companies. Maybe we should be addressing this issue in the growing laundry list of risks disclosed in today’s security registration statements and annual reports…it might read something like this:

Our chief financial officer lacks a strategic focus (and potentially other critical skills) which may negatively affect the execution of firm strategy, as well as the management of key processes and related risks. As a result, our operating results are likely to vary significantly from period to period and be unpredictable, which may cause our stock price to decline.

Too far-fetched you say?  Just check out Model N’s prospectus risk list…I think it would fit in nicely, particularly given the company’s recent struggles in the C-suite.

The “Best CFO”

Determining who might be the “best” CFO may be an impossible task because there are just too many determinants. As with so many of today’s rankings (e.g., best company, top college, etc.), there is simply no one answer because the metrics used in these CFO “studies” are generally biased, incomplete, or otherwise flawed.  The CFO role is a function of a variety of factors including organization age, growth, scale, industry, market, etc.  Small firms often get along just fine with using their controller to fill the role of financial leader. And other companies often bridge the gap between controller and CFO using temporary help providers like CFO Edge.  But as companies continue to grow, they realize the need for a CFO to specifically oversee the link between strategy and financial success.

When discussing what makes a CFO “the best,” I feel compelled to demystify the notion of the strategic CFO.  First, we have to understand just exactly what a CFO does, vis-a-vis the controller.  A controller’s duties generally center around such traditional financial and managerial reporting tasks as preparing financial statements, budgets, cash flow projections, performance measurement reports; and creating and monitoring accounting policies, procedures, and internal controls.  And recently, in larger (or more diverse) entities that are suffering the burden of GAAP overload, some of the controller’s financial reporting duties have been spun off into the Chief Accounting Officer position.

In contrast, the CFO’s role is to specifically link strategy to financial performance.  Every company engages in three primary activities: financing, investing, and operating.  The CFO plays a major role in orchestrating all three as a company strives to execute its strategy. Of course a CFO needs to be strategic!  Without a detailed understanding of how a company intends to create value for its customers and differentiate itself in the marketplace, there is little chance that a CFO will be effective.  After all, CFO financing activities will be driven by investment decisions that are made to execute corporate strategy.  So, it is not surprising that today’s CFO’s find themselves increasingly on executive management teams, involved in planning and implementing growth strategies, IPO’s, and acquisitions.  All of these activities clearly fall under “investing responsibilities.”  And to make good investments, the CFO has to be an expert analyst skilled in both financial and tax strategy, as well as risk management. 

But the CFO’s responsibilities don’t stop there…they need a strategic focus not only for their investing and financing roles, but also so that they can monitor the efficiency and effectiveness of the company’s business model.  For example, are all of the business model processes adequately financed and sourced?  And what about process evaluation and risk management?  In short, three terms define the role of today’s CFO: strategy, process, measurement. These provide the criteria by which CFO greatness should be evaluated.

Amy Errett, an experienced venture capitalist, seems to agree in a February 2010 Inc. article:

A great CFO must be a great strategic thinker, strong manager, have a strong business sense and have excellent finance skills.

Several McKinsey consultants also seem to support my contention that “one size does not fit all” when it comes to evaluating CFOs. They suggest that because management roles can vary by organization, industry characteristics, and investor demand, there may actually be different types of CFO's.  Their review of CFO's at the top 100 global companies by market capitalization revealed four profiles for today’s CFO: the finance expert, the generalist, the performance leader, and the growth champion. The finance expert is what we normally would have expected to fill the CFO position historically, a former accountant and controller with audit experience and an advanced accounting degree. The generalist CFO is typically an MBA with significant experience in strategy and business operations and strategy, but significantly lighter in accounting expertise.  The performance leader is simply a generalist CFO who specializes in restructuring situations.  Consequently, the performance CFO’s focus are costs, and performance metrics to assess progress on re-engineering efforts central to strategy execution.  Finally, there is the growth champion CFO whose role is to effect growth strategies through dramatic changes in resource allocation (i.e., acquisitions, divestitures, etc.).  Not surprisingly, the growth champion skill set includes those of the finance expert, generalist, and performance leader, as they must be able to address strategy, process, and measurement challenges across the firm. The McKinsey consultants, Agrawal, Goldie, and Huyett, sum it up as follows:

It would be simplistic to suggest definitive rules prescribing a specific CFO profile for general categories of company.

 And Kristina Salen, the new CFO at Etsy seems to also validate my perspective.  She definitely gets it.  At the top of her advice list on making better investments is “Invest in a Strategy,” followed by “Investing in the Entire Management Team.”  Particularly telling, is her admission that quarterly numbers have little to do with strategy, and likely are poor measures of strategic success.

So, it is simply ludicrous to suggest that CFOs can be somehow classified, compared, and ranked with any degree of validity.  How then will you recognize a top CFO?  You will know them when you see them…they follow this Grumpy Old Accountant’s “Ten Commandments.”

“Ten Commandments” for CFOs

  1. Be honest.  Robin Freestone, CFO at Pearson Group and chairman of the Hundred Group of FTSE CFO’s,  sums it up nicely: "Your greatest asset is your personal credibility. That will travel with you, no matter who you’re working for. Lose it, and you render yourself valueless. The only real way to maintain that credibility is to tell it like it is."
  2.  Honor thy creditors and investors.  Hold the interests and needs of these stakeholders above all others, including your own and those of your management team.  Remember that without the financing provided by these parties, your vision and strategy cannot be achieved.
  3. Put a premium on strategy and process.  As Lewis Carroll stated, “if you don’t know where you’re going, any road will get you there.”  A strategic focus implicitly fosters innovation and promotes world class performance.
  4. Run your own company.  Don’t turn the keys over to consultants…they will never understand your strategy and processes as well as you do, no matter their purported business acumen.
  5. Embrace risk and risk management.  Risk is fundamental to business model processes.  Avoid temptations created by financial reengineering...there is never a good “quick fix.”
  6. Be transparent.  Place a premium on clear, concise, relevant information, and communication.  Avoid MBA speak and accounting jargon.
  7. Make “real” performance measurement a priority.  Recognize GAAP reporting for what it is, a flawed, politically-based, judgment-ridden, and historically focused financial assessment.  Link strategy to performance by adopting a balanced scorecard perspective.
  8. Shun the “earnings game” and avoid all who play it.  Abandon all earnings management activities including aggressive accounting and non-GAAP disclosures.  Instead of asking your independent auditors to “bless” outrageous accruals, require them to do real audits which just might benefit the company.
  9. Think long-term when evaluating performance.  Reject all short-term performance metrics and related incentives, including stock based compensation.  Recognize that it takes time to get things done. Take your pay only in salary and bonus, after you have earned it. Man up!
  10. Respect experience.  Recognize the value that work history and a proven record of accomplishment actually bring to a company. Don’t mistake academic pedigrees, certifications, and high energy for real competence.   

This essay reflects the opinion of the author and not necessarily that of The American College, or Villanova University.

AuthorAnthony Catanach
The American Airlines - US Airways tie-up smacks of the last two singles shacking up due to expediency rather than out of love.
— Thomas C. Lawton, March 1, 2013, US News & World Report

The recent U.S. Department of Justice challenge to the proposed merger of American Airlines and US Airways (US Air) nudged this Grumpy Old Accountant to see what all the fuss was about.  Critics of the deal argue that the combination will reduce competition and choice, and also lead to higher prices.  However, none of the criticism to date has addressed the potentially misleading financial picture that the creditors, courts and regulators may be getting from the accountants about the financial health of the entity emerging from bankruptcy (post BK firm). The accounting culprit this time is something called “fresh-start” accounting.  For those of you unfamiliar with this reporting tool, John M. Bonora provides an excellent summary of “fresh-start” accounting in “Fresh-Start Reporting: An Opportunity for Debtor Companies Emerging from Bankruptcy.” Note the use of the word “opportunity”…

One would think that the reorganized entity would be financially sound and stable, right?  And shouldn’t the new shareholders have some prospect of earning a return on their investment?  Well, this is exactly the picture that this financial reporting “gimmick” helps a post BK firm paint.  Rather than continuing the reporting of the old bankrupt entity, fresh-start financial reporting reflects a new entity with no beginning retained earnings or deficit with asset and liability values that are reset to their fair value.  Sounds theoretically appropriate, right?  Well, as with so many things, it’s the execution that’s the problem.

Not surprisingly, Jon Weil noted this problematic accounting back in 2010 when General Motors emerged from Chapter 11 bankruptcy protection. At that time he used terms like “funky numbers” and “fluffy balance sheet” to describe the less than transparent financial reporting caused by this accounting technique. And I applaud Jon for his excellent descriptors.  So what’s the problem: our old friend goodwill.  As Jon pointed out, goodwill normally results from a buyer paying an excess purchase price in an acquisition.  But when a post BK firm adopts “fresh start” reporting, the goodwill is something quite different, causing the company to appear to be financially healthy, when it is not.

Let’s see just how new American’s “fresh-start” balance sheet might look.  First, we have to come up with an estimate of the post BK firm’s reorganization value.  Generally, reorganization value is computed using a variety of different factors including forecasts of operating results and cash flows of the new entity.  In the case of new American, this is a big problem given its continued negative operating results and cash flows.  And since the “bride and groom” in this potential union did not share their blissful forecasts with this Grumpy Old Accountant, I decided to rely on the market to create an estimate of new American’s “fresh-start” balance sheet.

I estimated the value of the merger deal to currently be about $12 billion.  This valuation is based on the recent average price of US Air common stock ($16) multiplied by the its diluted number shares reported in US Air’s most recent 10-Q, page 5 (207,439,000 shares).  This means that US Air’s investment in new American is worth $3.319 billion.  Since US Air shareholders would own only 28 percent of the new American Airlines group after the merger, reorganization value would be approximately $12 billion ($3.319 billion divided by 28 percent).  This essentially also yields total stockholders’ equity for new American.

According to “fresh-start” accounting rules (ASC 852-10-45-20): 

the reorganization value of the new entity shall be assigned to the entity’s assets and liabilities in conformity with the procedures specified by Subtopic 805-20 (Business Combinations – Identifiable Assets and Liabilities, and Any Non-controlling Interest).

In short, the accounting is similar to that applied to purchase business combinations, with reorganization value being analogous to the purchase price in an acquisition.  So think of the $12 billion as the purchase price.  This total value then is to be allocated to the identifiable assets and liabilities of the entity with any excess being allocated to goodwill.

At this point, a simplifying assumption is in order.  Given that new American is coming out of bankruptcy, where it’s balance sheet values were clearly scrutinized and adjusted, I assume that any fair value adjustments to its balance sheet will be minor, and that its June 30, 2013 asset and liability values approximate fair value.  Based on my review of US Air’s fair value note, I made the same assumption for it.  By the way, since this is likely a “tax free” reorganization, the deferred tax values are likely to remain relatively unchanged, as there will be no tax deduction for reported goodwill (i.e., a permanent difference).  So, to compute a pre “fresh-start” balance sheet for new American, I simply added the June 30, 2013 balance sheets for both companies together as illustrated below.   

 Now comes the fun part.  According to American’s 10-Q, liabilities subject to compromise totaled $5.834 billion at June 30, 2013.  Since these parties will ultimately get common equity according to the transaction terms, I backed these obligations out of debt and added them to common equity (noted by (a)).  However, to balance to the $12 billion reorganization value/shareholders’ equity number, I deducted $575 million from common equity and goodwill.  Next, I zeroed out retained earnings by adding $15.583 billion to goodwill.  The result…a $52.6 billion behemoth with over 30 percent of its assets in goodwill!

Not a problem you say?  Well then, just where did the goodwill come from? It is nothing more than capitalized prior year old American LOSSES. I would not have a problem at all with this so called “fresh-start” intangible if we renamed it “Prior Company Capitalized Losses.”  Now that would be transparent!  Probably wouldn’t be too good for future stock prices, huh?  And impairment would likely be assured…

Still not convinced.  Then consider the view of Thomas  Lawton who indicates:

beyond operational and financial synergies, this merger does not, in and of itself, fix many key competitive challenges that beset both airlines.

So just why would we expect new American’s goodwill to have any value?  An if Lawton is correct, there also is little likelihood that any new “identifiable intangibles” other than goodwill will find their way to new American’s “fresh-start” balance sheet, thus reducing goodwill.  

Many of you are probably thinking, everybody does it…so what?  And you’d be correct.  After all, Delta Airlines used “fresh-start” reporting on its emergence from bankruptcy in 2007.  But new American’s goodwill will dwarf that of Delta.  Using accounting data from Wharton Research Data Services Compustat for FYE 2012, this is how new American stacks up with other major players in the airline space when it comes to intangibles, intangibles to total assets, and tangible stockholders’ equity:

Should my estimates hold, new American’s goodwill number will swamp that of the other major carriers.  If we are to believe the analyst Hewitt Heiserman, that a ratio of intangibles to total assets over 20 percent is a cause for concern, then we should really be worried.

As if this projected goodwill amount is not high enough, there’s also the potential for this intangible to go even higher than my forecast.  Any increase in “fresh-start” liabilities might add more goodwill.  For example, old American has a significant amount of off-balance sheet arrangements that just might qualify for the “fresh-start” balance sheet (e.g., liabilities related to variable interest entities, special facility revenue bonds, general operating leases, etc.).  Also, if US Air’s stock price goes higher, then the “excess purchase price” will increase, again yielding more goodwill.

Then there is the issue of negative tangible stockholders’ equity.  After deducting the aforementioned Prior Company Capitalized Losses from “fresh-start” stockholders’ equity, new American finds itself with a negative tangible stockholders’ equity number of $4.4 billion.  This brought to mind an eloquent statement made by Tom Selling of the Accounting Onion when discussing the accounting anomaly called “negative shareholders’ equity”:

Who wants to invest in a company, especially after fresh-start accounting is applied, whose assets and liabilities are so obviously out of whack?

And I couldn’t agree more.  Despite all of the cost reductions and labor agreements and revenue enhancements noted by old American in its FYE 2012 10K (page 38), the fact of the matter is that negative tangible stockholders’ equity means the post BK firm will have more liabilities than income producing assets…clearly, “out of whack.”

Finally, there is the virtual certainty of future write-offs of the “fresh-start” goodwill.  Old American even acknowledges this possibility in its FYE 2012 10-K (page 28).  And to make matters worse, the airline industry has a recent history of goodwill write-offs.  According to a study by the Financial Executives Research Foundation conducted by Professor Mark Holtzman and William Sinnett, airlines impaired 65 percent of their goodwill during 2008.  For example, in July of 2008, both United Airlines and US Air wrote off significant amounts of goodwill, $2.2 billion and $622 million, respectively.  US Air’s charge is particularly noteworthy because it related to goodwill from its America West merger which occurred just three years earlier in 2005.  

So what’s the take-away here?  Courts, creditors, and regulators beware!  The post BK firm is likely not as healthy or viable as the accounting magic of “fresh-start” reporting would suggest.  As a final decision on this merger transaction nears, I would encourage decision-makers NOT to ignore economic reality. This industry is characterized by fierce service and price competition, fuel cost volatility, high debt levels, and a host of factors that put a premium on “real” financial strength.  Does the post BK firm have a chance?  The “fresh-start” numbers seem to say yes, but…

Courage is doing what you’re afraid to do. There can be no courage unless you’re scared.
— Eddie Rickenbacker

Scared yet? 

This essay reflects the opinion of the author and not necessarily that of The American College, or Villanova University.

AuthorAnthony Catanach
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During the past few weeks, we have been flooded with countless notices on the advent of a “new audit report.” According to at least one such article, an “extreme makeover” is needed to address growing investor concerns about company performance and Big Four accounting firm (BFA) audit quality.  However, any debate over a “new audit report” is a poor use of time, as the solution to accounting restatements and declining audit quality likely resides with corporate management, not the accountants.

And the recent London Whale case provides a clue as to what really may be ailing financial reporting today. The fact that portfolio losses could be hidden in a global financial services firm with the stature of J.P. Morgan Chase is astounding, particularly given the lessons that should have been learned from the Financial Crisis of 2007, and past trading scandals at UBS, Barings Bank, and the like.  

As with so many high profile “accounting failures” since the turn of the century, the major problem was NOT really with the accounting, or even the auditors.  Sure, both could have been better, but the real culprit in virtually all of these cases was the company itself!  And recent investigations appear to confirm the same result in the recent Whale Case: an internal controls failure.

So, exactly what are these things called “internal controls?”  Well, the Committee of Sponsoring Organizations (COSO) of the Treadway Commission defined internal control broadly as: 

a process, effected by an entity’s board of directors, management, and other personnel, designed to provide reasonable assurance regarding the achievement of objectives relating to operations, reporting, and compliance.

Still not clear?  Well, the Center for Audit Quality adds a bit more specificity suggesting that:

internal control includes all of the processes and procedures that management puts in place to help make sure that its assets are protected and that company activities are conducted in accordance with the organization’s policies and procedures.

All sounds pretty technical and boring, huh?  Well, simply put, internal controls are how management makes sure the company’s business model is operating correctly.  

Since both managers and investors need timely and accurate information, internal controls over financial reporting (ICFR) in particular have attracted a lot of attention over the past four decades, usually in response to some catastrophic audit failure or accounting collapse:

  • The Foreign Corrupt Practices Act of 1977 (“FCPA”) first required public companies to establish and maintain a system of internal control.  
  • Then, in 1985, the National Commission on Fraudulent Financial Reporting (the Treadway Commission) recommended that COSO develop a common perspective on internal control, which ultimately happened seven years later. 
  • Finally, the Sarbanes-Oxley Act of 2002 required public company management to annually assess the effectiveness of ICFR, and report the results to the public. 

However, an ICFR focus is limited in that it restricts attention primarily to accounting systems that support financial reporting. Consequently, accountants and auditors tend to view ICFR mechanically and procedurally, often ignoring internal controls outside the accounting systems.  And that’s a problem!

Lin and Wu note that accounting did not cause recent corporate scandals, management did. The misleading financial statements characteristic of most accounting and audit failures resulted from poor management decisions, often the result of weak or non-existent internal controls.  So, making accountants and auditors scapegoats for bad management, masks the real issue.

And just how bad is this internal control problem?  Well, if we focus solely on ICFR, it’s pretty discouraging.  According to Audit Analytics, management reported ineffective ICFR in almost 20 percent of registrants over the past three years.

And the internal control breaches are not isolated to any one particular area according to Chao and Foote, who researched public company deficiencies between 2004 and 2011.  

So, why might this be the case?  One major factor just might be the pressure to innovate.  In their rush to be perceived as “world class,” companies are striving to create high customer value (i.e., world class effective), through low-cost operating models (i.e., world class efficient).  Today’s business leaders routinely label business process reengineering as innovation as they seek ways to grow margins, often through aggressive cost cutting.  And frequently the target of cost reduction is middle management, where many internal controls often reside, as noted by Melissa Korn in “What’s It’s Like Being a Middle Manager Today:” 

What’s different now is that companies are leaner than ever, placing greater demands on staff even as they invest in technology that threatens to eliminate many jobs. Companies are asking managers to do more, challenging them to create and innovate while still developing talent and meeting deadlines.

And Lynn Brewer in “Fraud’s House of Cards,” warns us of the possible unintended consequences of aggressive restructuring activities:

Finally, as layoffs or reorganization may become necessary, the key to success is going to be flexibility and agility versus cutting corners, which may lead to fraud.

Next, the popularity of inorganic growth strategies (i.e., mergers and acquisitions (M&A)), particularly in the technology, healthcare, and financial sectors, also may have contributed to the breakdown in internal controls.  Given the historically high failure rates of most M&A transactions, often due to poor post-merger integration, I would not be shocked to see poor internal controls as an outcome in most of these M&A deals.  And recent federal securities class action litigation seems to confirm my concerns about M&A transactions in general, and ICFR.

Finally, there is the sad, but simple truth that far too few of today’s managers really understand what goes into creating and executing a good business model.  And key to the effective functioning of a business model’s processes are the aforementioned internal controls over systems and reporting.  Managers must not only “talk the talk,” but also “walk the walk,” when it comes to business model details.

And the current situation has the potential for even getting worse. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 exempted companies with less than $75 million in public float from having an auditor report on ICFR.  And last year’s Jumpstart Our Business Startups (JOBS) Act legislation also provided disincentives to build solid internal controls.  According to Chris Dieterich in a recent Wall Street Journal article:

Nearly three-quarters of the 87 U.S. companies that publicly filed their IPO registration between the start of April and year- end counted themselves as “emerging-growth,” the data showed…Every emerging-growth company that filed IPO documents last year used JOBS Act provisions to opt out of outside audits of their internal controls for longer than previously allowed…

Proponents of “emerging-growth” company (EG) internal control reporting exemptions claim cost savings that promote business development.  The reality is that most EGs simply have no internal controls.  

In fact, this Grumpy Old Accountant recalls participating as a staff auditor in a tech company IPO several decades ago.  This client’s claim to fame was the development of a “super slow-motion” camera lens that eliminated blur from still pictures taken at sporting events.  The hope was that the engineer-owners of the firm would enrich themselves with the rapidly approaching summer Olympics.  However, a major IPO hurdle was that the company had no books and records!  The owners literally brought grocery bags filled with receipts and cancelled checks into our then Big Eight firm office conference room.  From those documents we then constructed and “audited” a set of financial statements for the IPO registration statement.  Do we really believe it is all that much different today?  I seriously doubt it…

Interestingly enough, a recent governmental report linking exemption from ICFR attestation with accounting errors has not received much press. The U.S. Governmental Accounting Office (GAO) found that the number of accounting errors (i.e., restatements) was higher for companies exempt from auditor attestation of ICFR than for nonexempt companies from 2005 to 2011.  As a result, the GAO recommended that the U.S. Securities and Exchange Commission (SEC) require all public companies to disclose whether they obtained an auditor attestation of their ICFR to increase transparency for investors.  Is this really too much to ask of companies seeking access to our capital markets?  

But there does remains one thorny issue…who can we trust to report on a company’s internal controls? Apparently the BFA are not only poor financial statement auditors, but according to the Public Company Accounting Oversight Board (PCAOB), they also aren’t very good at evaluating internal controls, even after presumably all of the “experience” they gained doing Sarbanes-Oxley 404 work. Or should that work be suspect as well?  Should we really be surprised that technical GAAP specialists don’t know a thing about business processes?

So where does all of this leave us?  As Albert Einstein said, “ In the middle of difficulty lies opportunity.” Here are a couple of thoughts:

  • Given the recent shift to principles-based accounting (i.e., reliance on management judgment), continued decline in BFA audit quality, and the ever-widening “expectations gap,” it may be time to de-emphasize reliance on “audited” financial statements.
  • Instead, require ALL publicly traded companies to have a periodic, independent third-party evaluation of their internal control systems, including ICFR.  This evaluation would be performed by a non-BFA firms selected by the SEC on a rotational basis, and paid for by the publicly-traded company being examined.  Companies could actually lower their review costs by having high quality control systems that might actually contribute to strategy execution.
  • The PCAOB could shift the majority of its oversight duties away from evaluating financial statement audits to monitoring internal control evaluations.

This internal controls focus just might end the fruitless debates about auditor rotation, partner signatures, and the like.  It also could grow the market for “audits” of internal control systems, and encourage the development of new internal control specialist firms other than the BFA, thus diminishing the current “too few, to fail” concerns of the regulators.

With all of the accounting and auditing problems bombarding us today, we should focus on the common denominator: most accounting errors and audit failures have their roots in the failure of a company’s internal controls.  Consequently, management should be held responsible for this crisis in investor confidence, not the accountants.  And it sure seems like internal controls are central to earning this confidence.  If not, we are left with the old idiom: garbage in, garbage out!

AuthorAnthony Catanach