Class 7
Financial Reporting, Corporate Control
and
Shareholder Activism
Financial Reporting
Section 1
Financial Reporting
Accurate financial reporting is critical for the efficiency
of capital markets and the proper valuation of securities
It allows the board and investors to make an informed
evaluation of strategy, business model, and risk
It also allows the board to structure compensation
packages appropriately and award performance-based
compensation knowing that predetermined targets
were met
The Audit Committee
The audit committee has a broad range of responsibilities:
Oversee financial reporting and disclosure
Monitor choice of accounting principles
Hire and monitor the external auditor
Oversee internal audit function
Oversee regulatory compliance
Monitor risk
To ensure that its work is free from management influence:
All committee members must be independent
All members must be “financially literate”
One member must be a “financial expert”
Financially Literate
Understand the transactions that require judgments described
Understand the accounting and measurement issues for policies
and estimates
Understand management’s choices among policies and methods
for making estimates and the reasons for them
Understand the implications of management choices for the
potential manipulation of financial reporting
Audit Committee Financial Literacy: A Work in Progress
By Douglas J. Coates, M. Laurentius Marais and Roman L. Weil
Financial Expert
An understanding of U.S. GAAP and financial statements
The ability to assess the general application of U.S. GAAP in
connection with accounting for estimates, accruals, and reserves
Experience preparing, auditing, analyzing, or evaluating financial
statements that present a breadth and level of complexity of
accounting issues or experience actively supervising persons
engaged in such activities
An understanding of internal controls and procedures for financial
reporting
An understanding of audit committee functions
Testing the Financial Literacy and Expertise of Audit Committee Members
By Don E. Giacomino, Michael D. Akers, and Joseph Wall
Accounting Quality
The audit committee establishes guidelines that dictate the
quality of accounting used in the firm:
Quality: the degree to which accounting figures precisely reflect
changes in financial position, earnings, and cash flow
Transparency: the degree to which the company provides details that
supplement and explain accounts reported in statements and filings
Internal controls: the processes and procedures that ensure
transactions are accurately recorded, financial statements reliably
produced, and company assets protected from theft
Accounting Quality: Evidence
Companies are much less likely to report a small decrease in
earnings than a small increase
Managers make small manipulations in accounts so that net
income figures are rounded up rather than down
Companies that beat earnings with “low-quality” earnings
have better short-term but worse long-term performance
Burgstahler and Dichev 1997
Financial Restatements
A restatement occurs when
a material error is found in
the company’s previously
published financials
700 to 1,700 U.S. public
companies restate each
year
3%
4%
7%
10%
11%
13%
13%
14%
23%
30%
0% 10% 20% 30%
CONTINGENCIES
LEASES
COST OF SALES
DEPRECIATION &
AMORTIZATION
TAXES
INVESTING
STOCK-BASED
COMPENSATION
REVENUE RECOGNITION
FINANCING
ACCRUALS & RESERVES
REASON FOR RESTATEMENT
(2003-2012)
Reasons for Restatements
A restatement can occur because of human error, aggressive
accounting, or fraud
The reasons for restatement have implications on the quality
of controls in the company and the steps needed to remedy
Some evidence that financial fraud is correlated with weak
governance
Few outside directors
Low director stock ownership
Busy boards
Fewer accounting meetings and financial experts on audit committee
CFO lacks financial expertise (Aier et al. 2005)
Companies exhibit 5% median stock price decline following
announcement of restatement; decline is 20% if due to fraud
Accounting Manipulation
Accrual accounting recognizes revenues and expenses in the
period realized and not when the underlying cash is received
or paid
Reduces variability but relies on managerial assumptions and
therefore subject to manipulation
Abnormal accruals is the difference between accruals and
cash flows after adjusting for usual or normal accruals that
occur based on the company’s accounting process
Models to Detect Manipulation
Researchers have put tremendous effort into developing
models to detect fraud with limited success
One set of models measures accounting quality in terms of
“abnormal accruals” (the degree of divergence between
reported net income and actual cash flows)
Another set of models analyzes both accounting and
governance data which improves success rate slightly
Recently, researchers have explored linguistic analysis of CEO
and CFO speech which can improve success rate
Precision in models is low (less than 10%)
External Audit
The external audit assesses the validity and reliability of
publicly reported financial information
Because management is responsible for preparing financial
reports, shareholders expect an objective third party to
provide assurance that the information is accurate
Despite public expectations, it is not the explicit objective of
the audit to identify fraud
Instead, the objective is to express an opinion on whether
statements comply with accounting standards
Auditors express an “unqualified opinion” if it finds no reason
for concern
External Audit Process
Audit preparation: Determine scope of audit. Identify areas
requiring special attention
Review estimates and disclosure: Sample key accounts. Test
managerial assumptions. Independently verify estimates
Fraud evaluation: Review opportunity for fraud. Examine
incentives for fraud. Use “professional skepticism”
Assess internal controls: Examine design. Identify
weaknesses. Focus on key accounts and unusual transactions
Conclude: Review findings with audit committee. Express an
opinion to accompany the financial statements
Audit Opinions
Unqualified
Qualified
Adverse
Going concern
Disclaimer
Audit Quality
Given the importance of the audit, much attention has been
paid to factors that might impact audit quality
Potential issues include:
Conflict when auditor provides non-audit services
Conflict when former auditor is hired as CFO
Auditor rotation
Industry consolidation
Former Auditor as CFO
A company might decide to offer a job in finance, treasury, or
internal audit to a member of the external auditing team
Pros and cons?
(+) Auditor is familiar with company and its procedures
(+) Company is familiar with auditor working style
(+) Reduces both hiring costs and risk of failure
(-) Auditor might have allegiance to former employer
(-) Auditor knows internal controls, might facilitate fraud
Non-Audit Services
Auditors prohibited from performing certain non-audit
services
Pros and cons
(+) Reduces potential conflict of interest
(+) Might improve auditor independence
(+) Company cannot “retaliate” if it disagrees with auditor
(-) Auditor has expertise in company procedures
(-) Might be cheaper for company
Auditor Rotation
Auditor rotation is the practice of periodically changing
external audit firms
Pros and cons
(+) New auditor might be more independent
(+) New auditor has fresh perspective
(-) Costly to change audit firms or audit teams
(-) New auditor has a steep learning curve
PCAOB considering mandatory rotation
Auditor resignation vs. auditor dismissal – implications?
Industry Consolidation
In the late 1980s, there were eight major accounting firms
Now, the “Big Four”
Pros and cons of consolidation?
(+) Scale of audit firms matches the scale of companies
(+) Expertise by industry and region
(+) Expertise by function (tax, audit, systems, etc.)
(-) Inadequate number of firms to choose among
(-) Decreased competition might lead to increased fees
Impact of Sarbanes-Oxley
On Audit Profession
Before SOX
Self-regulated based on GAAS
Peer review every 3 years
Compliance with quality control systems
After SOX
PCAOB inspections – large firms annually; small firms every 3 yrs
Risk based, tone from the top, more latitude
Overall, SOX
Reduced potential conflicts of interest/more independence
Introduced regulatory oversight of the profession
Increased cost to companies
Global Accounting Firms
Network of firms, not one global entity
Owned and managed independently with agreements with
other member firms in the network to share a common
name, brand and quality standards
Each member firm practices in a single country, and is
structured to comply with the regulatory environment in
that country
Market for Corporate Control
Section 2
Disciplining Mechanisms
A well-functioning governance system consists of more than
just the board of directors and the external auditor
Includes all disciplining mechanisms—legal, regulatory, and
market driven—that influence management to act in the
interest of shareholders. Examples include:
Labor market: Failure leads to CEO termination
Capital market: Failure leads to higher cost of capital
Regulatory environment: Violations lead to litigation
Similarly, the “market for corporate control” puts pressure on
the CEO to perform, or risk sale of company to new owners
The Market for Corporate Control
All mergers, acquisitions, and reorganizations—including
those by a competitor, a conglomerate, or a private equity
er
Acquirer (or bidder) vs. target
Friendly vs. hostile
In a tender offer, the acquirer makes an offer directly to the
target shareholders to purchase their shares at a stated price
In a proxy contest, the acquirer asks target shareholders to
elect a dissident slate of directors to approve the deal
Strategic Reasons for an Acquisition
Financial synergies: The acquiring firm believes it can increase
profits through revenue improvements, cost reduction, or
vertical integration. This is the logic behind a strategic er
Diversification: Two companies whose earnings are
uncorrelated might benefit by relying on the capital
generated when one business is thriving to help the other
when it is struggling. This is the logic behind a conglomerate
structure
Change in ownership: New owner group might have superior
access to capital, managerial expertise, or other resources.
This is the logic behind a private equity er
Nonstrategic Reasons for an Acquisition
Empire building: The acquirer purchases a target primarily for
the sake of managing a larger enterprise
Hubris: Overconfidence on the part of management that it can
more efficiently manage a target than current owners can
Herding behavior: The senior management of one company
pursues an acquisition because its competitors have recently
completed acquisitions
Compensation incentives: The management of the target
company agrees to an acquisition primarily because it stands
to receive a large payment upon change in control
Who gets acquired?
Companies that
are fundamentally weak performing
are in industries with heightened merger activity
have low debt levels
have strong cash flows
have valuable assets
The Expected Value of a Takeover
Research has routinely shown that markets expect the
incremental value of an acquisition to flow to the target
rather than to the acquirer
The target:
Receives double-digit takeover premium offer
Experiences greater excess returns in hostile deals
Experiences greater excess returns in all-cash deals
The acquirer:
Experiences no excess returns following bid
Experiences negative excess returns for hostile bid
Experiences greater declines if equity-financed bid
The Realized Value of a Takeover
Research has also shown that acquirers realize less value
following a merger than originally expected
The acquirer:
Underperforms peers on a one- to three-year basis
Performs worse if acquisition is financed with equity
Decreases investment in working capital and capital expenditure
Acquisitions are also highly disruptive:
They require significant management attention
They lead to elevated turnover rates for up to 10 years following
consummation of the deal
Antitakeover Protections
A company that does not want to become the target of an
unsolicited takeover might adopt defense mechanisms to
discourage or prevent a bid
Antitakeover protections might give a company time to pursue
long-term value creation without threat of takeover; or to
enhance bargaining power to secure a higher bid
Problem – could be a manifestation of agency problems like
management entrenchment
Antitakeover Protections
Common antitakeover protections include:
Poison pill (28%)
Dual-class shares (8%)
Staggered board (50%)
Restricted rights to call a special meeting (47%)
Shareholders cannot vote by written consent (30%)
Poison Pill
A poison pill grants holders of the company’s shares the right to
acquire additional shares at a deep discount to market (e.g., $0.01
per share)
The poison pill is triggered if a shareholder accumulates an
ownership position above a threshold (e.g., 15 to 20 percent)
If the threshold is exceeded, the market is flooded with new
shares, making it prohibitively expensive to gain control
Markets react positively to adoption of poison pill if company’s
board has majority outside investors and negatively otherwise
Companies that adopt a plan are twice as likely to defeat an
unsolicited offer
Dual-Class Shares
A company with dual-class shares has more than one class of
common shares; each class typically has proportional
ownership interests but disproportionate voting rights
The difference between economic interest and voting interest
is known as the “wedge”
The class with favorable voting rights typically does not trade
in the market but is instead held by insiders, founders, or
another shareholder friendly to management
Dual-Class Shares
Google
Class A (GOOGL), Class B, Class C (GOOG)
Class A shares represent 1 vote each
Class B shares represent 10 votes each (Larry Page, Sergey Brin, Eric
Schmidt, etc.)
Class C shares have no voting rights; primarily for ESOs and
acquisitions
As of 2015, founders had more than 50% voting rights though they
own just 12% of outstanding equity
Facebook, Zynga, Groupon, LinkedIn, Yelp, Zillow, Alibaba
News Corp, New York Times, Washington Post
Staggered Board
In a staggered board, directors are grouped into three classes,
each of which is elected to a three-year term and only one
class stands for election in a given year
A corporate raider must win two elections, one year apart, to
gain majority representation
A staggered board brings greater stability to the board;
however, it is a formidable obstacle (particularly when
coupled with a poison pill)
State of Incorporation
A company’s state of incorporation is important because state
law dictates most governing rights. A company might
reincorporate to a state with more protective laws
Example of restrictive state law (Pennsylvania):
Directors can consider impact of deal on stakeholders
Voting rights are curtailed for shareholders owning > 20%
Short-term profits must be disgorged
Severance must be provided to employees terminated in a deal; labor
contracts cannot be terminated
More than 50% of publicly traded companies are incorporated
in Delaware
State of Incorporation
The Delaware Effect
Reasons
Delaware General Corporation Law (simple and flexible)
Court of Chancery (established precedence and no jury cases)
Low cost (registration and corporate tax)
No residency requirements
Expert lawyers (specialized in corporate laws)
Supportive legislature (business friendly)
Summary of Antitakeover Protections
Summary of defenses by their level of protectiveness, from most
difficult to least difficult to acquire:
Companies that have either dual-class shares or staggered boards and
prohibitions on shareholder rights to call special meetings or act by
written consent
Companies with staggered boards but no limitations on shareholder
rights to call special meetings or act by written consent
Companies with annually elected boards but prohibitions on
shareholder rights to call special meetings or act by written consent
Companies with annually elected boards and full shareholder rights to
call a special meeting or act by written consent
Companies with no antitakeover provisions
Institutional Shareholders and
Activist Investors
Section 3
The Role of Shareholders
The “shareholder-centric” view
primary purpose of the corporation is to maximize wealth for owners
To that purpose, an effective governance system should
align the interests of managers and shareholders
reduce agency costs and increase shareholder value
What is an “effective” governance system?
not always easy to determine elements and features
investors are not a homogenous group
do not always agree about how to improve governance quality
Not All Shareholders Are the Same
Investment horizon: Long-term investors might tolerate volatility
if they believe value is being created. Short-term investors might
prefer that management focus on quarterly earnings and stock
price
Objectives: Mutual funds might care primarily about economic
returns. Other funds might emphasize how results are achieved
and the impact on stakeholders
Activity level: Passive investors might focus on index returns and
pay less attention to individual firms. Active investors might care
greatly about individual outcomes
Size: Large funds can dedicate significant resources to
governance matters. Small funds lack these resources
Other Limitations
Free-rider problem: Shareholder actions are expensive.
Although all shareholders enjoy the benefits, a few bear the
costs. This provides a disincentive to act
Indirect influence: Shareholders do not have direct control
over the corporation. They influence the firm by:
Communicating their concerns
Withholding votes from directors
Waging a proxy contest to elect an alternative board
Voting against company proxy items
Sponsoring their own proxy items
Selling their shares
Blockholders
Blockholders
are investors who hold a large ownership position in the company
are in a position to influence the governance of a firm because of the
size of their holdings
Blockholder actions depend on the nature of their relation to
the firm
Corporate partners will not take the same actions as activist
hedge funds
Proxy Voting
A primary method for shareholders to influence the
corporation is through the proxy voting process
Each year, shareholders are asked to vote on a series of
corporate matters, either in person at the annual meeting or
through the annual proxy
Institutional investors are required by SEC regulation to vote
all items on the proxy and to disclose their votes to investors
Proxy Voting
Management proposals are those sponsored by the company
election of directors, ratification of the auditor, approval of equity-
compensation plans, say-on-pay, anti-takeover protections, and bylaw
changes
Shareholder proposals are those sponsored by investors
more than 80% are sponsored by union funds and individual activists
generally relate to compensation, board structure, antitakeover
protections, and bylaw changes
may be excluded shareholder proposals if they violate the law, deal
with management functions, involve dividends, or involve other
substantive matters
33% relate to compensation while 20% are board-related (e.g., term
limit for directors)
Proxy Advisory Firms
Many institutions rely on the recommendations of a third-
party advisory firm to assist them in voting the proxy
Pros and cons
(+) Proxy firms examine all issues on the proxy
(+) Small investors lack the resources to do this in-house
(+) Large investors might want a second opinion
(-) No evidence that their recommendations increase value
(-) Guidelines tend to apply a one-size-fits-all approach
(-) Proxy firms might not have sufficient staff or expertise
Activist Investors
An activist investor is a shareholder who uses an ownership
position to actively pursue governance changes. Examples
might include:
Union-backed pension funds
Socially responsible investment funds
Hedge funds that take an active position
Individual investors with strong personal beliefs
Activist investors play a prominent role in the governance
process, sometimes for the better and sometimes not
Pension Funds
Public pension funds manage retirement assets on behalf of
state, county, and municipal government employees
Private pension funds manage retirement assets on behalf of
trade union members
Pensions are active in the proxy voting process. However,
their activism has not been shown to have a positive impact
on shareholder value or governance outcomes
Socially Responsible Funds
Socially responsible funds cater to investors who value
specific objectives and want to invest only in companies
whose practices are consistent with those objectives
Examples include fair labor practices, environmental
sustainability, and the promotion of religious or moral values
These funds are visible in the proxy process, although it is
only one tool they use to influence corporate behavior; proxy
items sponsored by these funds generally do not receive
majority support
Activist Hedge Funds
Hedge funds are private pools of capital that engage in a
variety of trading strategies to generate excess returns
Hedge funds are known for their high fee structure (2%
management fee, 20% carry). They face pressure from clients
to generate superior performance to justify these fees
Pressure to perform might encourage activism
Activist hedge funds target companies with high ROA and cash
flow, but below market price-to-book ratios and stock price
performance
Shareholder Democracy
In recent years, there has been a push by Congress, the SEC,
and others to increase the influence that shareholders have
over governance systems (“shareholder democracy”)
Advocates of shareholder democracy believe that it will make
board members more accountable to shareholder concerns,
such as excessive compensation, risk management, and board
accountability
Elements of shareholder democracy include:
Majority voting in uncontested elections
Brokers disallowed from voting in uncontested elections
Investor right to nominate directors (“proxy access”)
Investor vote on executive compensation (“say on pay”)
Majority Voting
Shareholder advocates believe that plurality voting lowers
governance quality by insulating directors from investors
They advocate a stricter standard—majority voting—under
which directors must receive 50% of the votes to be elected
The impact of majority voting on governance is unclear.
Dissenting votes are often issue-driven and not personal to
the director (e.g., vote against directors on compensation
committee to protest CEO compensation levels)
This might inadvertently work to remove directors who bring
important strategic, operational, or risk qualifications
Broker Nonvotes
Shares held at a brokerage firm are registered in the name of
the broker, even though they are beneficially owned by
individuals
If the broker does not receive proxy instructions from the
investor within 10 days of the vote, a “nonvote” occurs
NYSE Rule 452 allows brokers to vote these shares for
“routine” matters but not for “nonroutine matters”
Historically, uncontested director elections were considered
routine. In 2009, they were reclassified as nonroutine
Proxy Access
Historically, the board of directors has had sole authority to
nominate candidates whose names appear on the proxy
Following Dodd-Frank, shareholders or groups of shareholders
owning 3% or more of a company’s shares for at least 3 years
are eligible to nominate up to 25% of the board
Proxy access (or the threat of proxy access) is likely to increase
the influence of activist investors over boards
Say on Pay
Shareholders are given a vote on executive or director
compensation at annual meeting
Variations of “say on pay” have been enacted in the U.S., U.K.,
Netherlands, Australia, Sweden, Norway and India
Under Dodd-Frank, companies are required to hold a
nonbinding say-on-pay vote at least every 3 years
Conclusion
In theory, shareholders should be in a strong position to
influence the structure of governance systems
In practice, shareholders have limited influence, and in some
cases they have conflicting agendas
Regulators have attempted to increase the influence of
shareholders by mandating elements of “shareholder
democracy”
However, shareholders tend to react negatively to these
regulations and a positive impact on governance quality has
not yet been demonstrated
Slide Number 1
Slide Number 2
Financial Reporting
The Audit Committee
Financially Literate
Financial Expert
Accounting Quality
Accounting Quality: Evidence
Burgstahler and Dichev 1997
Financial Restatements
Reasons for Restatements
Accounting Manipulation
Models to Detect Manipulation
External Audit
External Audit Process
Audit Opinions
Audit Quality
Former Auditor as CFO
Non-Audit Services
Auditor Rotation
Industry Consolidation
Impact of Sarbanes-Oxley�On Audit Profession
Global Accounting Firms
Slide Number 24
Disciplining Mechanisms
The Market for Corporate Control
Strategic Reasons for an Acquisition
Nonstrategic Reasons for an Acquisition
Who gets acquired?
The Expected Value of a Takeover
The Realized Value of a Takeover
Antitakeover Protections
Antitakeover Protections
Poison Pill
Dual-Class Shares
Dual-Class Shares
Staggered Board
State of Incorporation
State of Incorporation�The Delaware Effect�
Summary of Antitakeover Protections
Slide Number 41
The Role of Shareholders
Not All Shareholders Are the Same
Other Limitations
Blockholders
Proxy Voting
Proxy Voting
Proxy Advisory Firms
Activist Investors
Pension Funds
Socially Responsible Funds
Activist Hedge Funds
Shareholder Democracy
Majority Voting
Broker Nonvotes
Proxy Access
Say on Pay
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