coursematerialtofollowonthecase.pdf

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
Conclusion