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CFO’s dilemma

|By Ramesh Mahalingam|

As someone who has worked in businesses across the ownership spectrum, I am tempted to pose this question to all aspiring CFOs:

All other factors being equal, what is the fundamental difference in the approach to the financial reporting function as between a publicly listed company and a privately-owned business?

The answer lies not in the IFRS standards, which by and large, do not prescribe different treatments based on the ownership structure of the entity. Nor does it lie in the notion of size, for there are several private companies that are larger than many quoted companies on most metrics. The answer lies in the fact that in a private company the accountants can afford to “go with the flow”, i.e., keep the score as transactions unfold, without having to chase a targeted figure to report to the owners, whilst their listed company counterparts are required to do some “profit-planning” as well as some “balance sheet planning”.

The latter are constrained by their shareholders’ fairy tale quest for a happily ever after upward trend in profits, and this, in turn, is due to the fact that most modern economies today are deeply grounded in their respective stock markets. What’s more, in most countries, the reporting frequency is as high as every 91 days when they are required to report their quarterly results. If you clip out weekends, this is a mere 65 trading days!

Where’s the dilemma here?

Combine these two phenomena – corporate management’s compulsion to look good to its shareholders by reporting a healthy financial result on the one hand, and short reporting cycles on the other – and you drive the CFO to constantly compute the run-rate required to meet some tall numbers by the quarterly deadline – numbers that had been previously projected to the market. Even if there was no such forward-looking statement issued, there is a tacit compulsion to want to show a higher result or metric (e.g., same store sales) than the previous quarter or the same quarter of the previous year. Sweep the headlines of the business pages just after a quarter-end and you will see the point I’m making here.

The reason for this obsession with showing better performance is that a failure to meet quarterly numbers almost always results in a punishing hit to the company’s share price. A drop in the company’s share price brings in its wake a host of problems – angry investors, activist shareholders, impact on stock options thereby lowering executive compensation, threats to management longevity, and so forth.

Hence, when the required run-rate is too high to be practical, the situation forces the CFO to resort to desperate measures to show the profits that the business operations have not been able to generate. A survey of over 400 CFOs of major US companies revealed that almost 4 out of every 5 of them would have moderately mutilated their businesses in order to meet analysts’ quarterly expectations (see citation below).

The measures themselves may range from the sublime to the ridiculous. Thus, we find companies selling assets of all descriptions to “book profits” – selling profitable investments, selling-and-leasing back operating assets, selling profitable subsidiaries or divisions (jewels) in their portfolio, cutting R&D budgets, chopping advertising spend, freezing hiring, delaying new projects, changing the depreciation parameters and other potentially long-term harmful measures. Some CFOs book profits even as they make investments at bargain prices. While I do not question the legitimacy of any of these measures – it is the independent auditor’s lot to do so – what I am not so sure of is the propriety or timing of that accounting adjustment or that sale, or for that matter, that purchase. In other words, had it not been for the pressure to report those profits, would they still have put those transactions or those accounting adjustments through? Are they, in their penchant to pacify the market in the quarterlies, setting the company up for failure in the final analysis? Extended to the extreme, would it not lead the company to join the ranks of an Enron, Worldcom, Tyco, Adelphia, Rite Aid, Global crossing or numerous others?

That said, I am quite certain that there are CFOs adroit in juggling the short-term need to keep share prices high with the longer-term health of the company in their husbandry. All the same, when the environment gets challenging, as with the current tectonic shifts in oil prices, global manufacturing and trade flows, these CFOs, as do their corporate managements, are faced with the challenging question of when they should abandon their chase to report higher profits, accept the hard reality and report the not-so-bright news to the market. This is as much a communications, PR and timing tactic as it is financial strategy, and in most situations, is easier said than done.

Where am I heading with all of this?

My purpose is to make the case for a change, hopefully for the better. A change that would allow company managements to train their focus on the creation of long-term value without being drawn into pandering to the short-term cravings of investors’ lust. In this effort we should perhaps, as a collective body of accountants, join forces with an equally affected community, the CEOs, and form the nucleus of a movement that denounces the short-term emphasis of the stock markets and its ill-effects over business behavior. I suggest some measures that will allow the C-suite to focus on long-term business initiatives without having to constantly answer the market’s insistent demands for price appreciation. These changes are somewhat fundamental in nature and might sound afar, but then all revolutions must begin somewhere.

  • Educate investors, fund managers and analysts that long-term business fundamentals are more important than short-term market-propping euphoria and hence should not be forsaken in favour of the latter. After all, profits come from industrial production and trading activities, not from the breeze that blows toward tomorrow. This is an oft-forgotten lesson in corporate capitalism that needs to be re-learnt by every successive generation of market participants in order to have responsible shareholder engagement.
  • Lobby with the authorities to make quarterly reports optional for corporations, and along with it, quarterly profit warnings.
  • Imbue in all aspiring CFOs the ability to adopt a discerning approach and to communicate effectively to the Board and to the wider market the dangers of sacrificing the long-term in favour of short term sustenance of the share price.

In conclusion, I can’t but think that until we bring about this radical change in the mindset of the market, the CFO remains vulnerable to its whims and winds.

(The speculation economy, by Lawrence E. Mitchell)

Ramesh Mahalingam is Founder and CEO of Ideal Management Consultants, Dubai

(Via LinkedIn)

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