Lax accounting, neglect of cash needs, supply-chain inadequacies, dirty data, faulty HR policies, weak governance and lack of contingency planning before a crisis can sabotage a business. Proactive CFOs head off such problems before they cause damage.
A few months after joining Synopsys Inc., a Mountain View, Calif., software and services firm, in early 2000, senior vice president and CFO Brad Henske nudged the company's accounting culture in a more conservative direction. The most significant change -- a new approach to software revenue recognition instituted in the fourth quarter of the company's fiscal year -- resulted in Synopsys's revenue guidance for 2000 dropping from more than $1 billion to $700 million. Earnings per share, which had been more than $3, dropped below $1. Yet the company's stock price increased (steadily, from $35 in September 2000 to more than $50 over the next four months) in response to the shift, thanks to the investment community's appreciation for Synopsys's long-term strategy.
That anecdote should inspire envy at a time when new stories about creative accounting, "round-trip trading," dubious loans to CEOs and other questionable corporate activities are cropping up daily in the business pages. Recent scandals leave no doubt that problems within the CFO's domain can mortally wound a business. As the focus on "good" and "evil" business practices intensifies, human nature tends to dwell on the negative. Synopsys garnered few headlines for its bold revenue-recognition move, but the company continues to reap benefits.
Finance executives who steer their organizations around tempting shortcuts offer similar explanations for those decisions. "It felt right to us," Henske says. "If you're providing software over a period of time, you should place the revenue over that same period of time." Asked how his company avoids lax accounting practices, Charles Harvey, president and CFO of Pixel Magic Imaging in San Marcos, Texas, responds that doing so is "more a matter of courage and integrity" than technique.
Fortitude on the part of the finance function is a necessary ingredient in the strategies that help companies avoid problems. CFOs who fail that gut check expose the credibility of their company's management to assault -- and trust is much more difficult to restore than an impressive share price. Courageous finance executives tend to rest easier at night and keep their organization's name out of negative headlines. Here are seven red flags that can indicate a finance team is heading down the wrong path.
1. The Dangers of Lax Accounting
There are three ways to recognize revenue for software products. First is a perpetual license, where the buyer pays a fee for the application and that revenue is registered in the quarter in which the sale took place. In addition, a maintenance and update stream, usually about 10 percent to 15 percent of the original purchase price, is paid and accounted for on an annual basis. Second is the term license, which is sold for a finite period of time -- three years is common -- and accounted for in the same way as a perpetual license. Third is the subscription, with which revenue from the license, as well as maintenance and upgrade fees, is recognized as revenue over the life of the subscription.
"If I book a three-year license for, say, $120,000," Henske notes, "that's $10,000 of revenue a quarter for the next 12 quarters, as opposed to $120,000 this quarter." In 2000, Synopsys moved roughly 75 percent of its business from a combination of the first two recognition methods, which most software companies follow, to the subscription model. The company still writes perpetual licenses because some customers, particularly those outside the United States, prefer that arrangement. "When we launched this, there was some trepidation," Henske says. "We knew we were doing the right thing for the long term. The question was, would that get recognized in the short term?"
It did, thanks to the company's ensuing communication blitz to Wall Street and other stakeholders. The campaign hammered home the point that the change would keep cash flow ahead of revenue and significantly decrease volatility. Synopsys's unusual accounting for software revenue also prevents customers from using the end of a quarter to strengthen their position in price negotiations.
Large, publicly owned companies are not alone in their quest to develop and maintain accounting cultures that are above scrutiny. "We're constantly asking ourselves if we're being honest with ourselves," says Harvey. "Is the way that we're looking at our business consistent with the way it really is? In every accounting interpretation, our standing goal is not to get the right answer but to reflect the economic essence of the transaction. And we openly communicate amongst ourselves and with our auditors about all of the alternative interpretations before making the best decision."
Harvey sounds like he's talking about the accounting practices of a large company, like Pepsi, for which he steered the Pizza Hut Mexico division for six years. But he's not. Pixel Magic is a closely held, venture capital-backed digital photo imaging business. Still, Harvey says, keeping the accounting pristine "is important to us." He adds, "We're constantly positioning ourselves to be one of those publicly held companies, and creating an environment of honest and open accounting now is integral to us."
2. Failure To Anticipate Cash Needs
Access to cash has become a make-or-break factor in the corporate world. The good news from a recent survey report by Standard & Poor's (S&P) is that less than 3 percent of the 1,000 companies analyzed showed "serious vulnerability to rating triggers or other contingent calls on liquidity, which could turn a moderate decline in credit quality into a liquidity crisis." Only 23 participating companies faced a likelihood of encountering a "credit cliff," which occurs when credit deterioration is compounded by rating triggers or financial covenants -- which, in turn, put pressure on the company's liquidity to a material extent.
More important is the report's revelation that S&P now conducts its financial statement analyses with much greater skepticism. Citing recent evidence of eroded auditing practices and the "tyranny of short-term performance pressures" that have contributed to more aggressive accounting practices, another S&P statement suggests that fundamental credit analysis must be supplemented with contributions from forensic accountants. CFOs who keep their companies a safe distance from liquidity crises credit a balanced approach to guiding, tracking and analyzing growth.
"Often in a forecast, you'll focus on the P&L, but the balance sheet implications are so often overlooked," says Mark Rowe, a partner in Tatum CFO Partners' Austin, Texas, office. "To sustain your growth, what is required in terms of your inventory and A/R build-up? Those each tie up cash."
CFOs who have equipped their companies with sharp forecasting capabilities and convenient access to cash often cite the adage about borrowing money when you don't need it. "Many times, the point at which it seems like a company has achieved great success is the point in time when the company has a great need for cash," Rowe notes. "Yet many lenders can be very reluctant at that point because of liquidity issues."
Savvy CFOs keep abreast of which lenders have an appetite for the type of financing their company needs. "We're in an atmosphere now where banks are becoming less and less forgiving, so what happens if the banks do call your loan?" adds Rowe. "I think that also gets back to having the courage to understand that growth for growth's sake is not always wise. There are prices to pay and risks to assume if you can't finance that growth. Many businesses that look like they're very successful get into a lot of trouble when they focus solely on the P&L."
3. Supply Chain Blindness
If cash is still king, as Rowe emphasizes, visibility may be heir to the throne. Cisco discovered this in early 2001 when it buckled under the weight of a massive inventory miscalculation. Pixel Magic learned a similar but much less costly lesson a year earlier. "We wrote off a fair amount of inventory when I arrived in September 2000," says Harvey, who swiftly moved the enterprise toward just-in-time inventory processes with key suppliers and a "multifaceted view" of the business to strengthen forecasting capabilities.
The company maintains constant communication with its critical suppliers: the computer manufacturers, cabinet makers and printer vendors that contribute to the digital imaging machines Pixel Magic places in grocery chains, drug stores and other retail locations. "We have about 10 suppliers in those three categories, and we constantly update each other so that we know where their products are and they know as far out as possible when we see spikes in our business," Harvey explains. As a result, those key components, which comprise about 80 percent of the cost of creating Pixel Magic's products, are purchased on an order-by-order basis and turned within two weeks.
Pixel Magic also conducts a macro-market forecast based on analyses of customer segments, a profile of competitive offerings and an estimate of reasonable penetration. As a sales prospect moves through the pipeline, Pixel Magic managers evaluate 75 criteria to determine the likelihood and magnitude of a potential sale. They compare those analyses with current revenue to strengthen the accuracy of the company's final revenue forecast.
To gain this degree of insight into its supply chain, a company must leverage software products such as forecasting tools, budgeting applications, analytics and supply-chain management (SCM) applications. Rapidly emerging enterprise contract management solutions illustrate the importance of visibility in the IT context. Sempra Energy, an $8 billion energy holding company, recently invested in a contract management solution from Accruent to adopt a single view of the company's entire real estate portfolio.
CFOs who have removed their IT blinders can help their companies leverage greater value from big-ticket investments. "The CFO is playing an increasing role in harnessing value out of IT infrastructure and ERP systems," notes Paul Boulanger, partner, finance and performance management, with Accenture in Atlanta. "I think the CFOs who are actively engaged in the IT agenda create competitive advantage for their companies in their industry sectors. Those who are not, or who are hamstrung by organizational disconnects to IT, are at a disadvantage."
4. The Perils of Dirty Data
A quieter way to cripple the effectiveness of key applications is to neglect data quality. Dun & Bradstreet, based in Murray Hill, N.J., updates its global database of more than 70 million companies every 3.9 seconds. According to D&B, a corporation fails every three minutes, a new business is formed every five minutes, a company changes its name every 15 minutes and a directorship changes every 32 seconds. How much out-of-date information occupies important fields in your ERP, CRM or SCM applications?
No matter how sophisticated IT systems are, they're only as reliable as the data flowing through them. As it accumulates, inaccurate information hampers relationships with customers and suppliers, adds to the cost of doing business (by creating duplicate work and the need for additional storage space), and saps employee confidence in expensive software investments.
"When data quality within an application deteriorates, you don't gain the effectiveness you were sold when you bought the application," says Chris Lucas, vice president with D&B. "The companies that have been successful at CRM, for example, have very early in the process recognized that they need to plan and invest in a data management strategy."
Lucas cites three steps companies can take to defend against data deterioration. First, he suggests, establish dedicated resources, such as a data management department that resides outside the IT department and serves as a sort of internal affairs unit that investigates and ensures data quality. "We've seen the rise of a new title, the data steward," Lucas adds. "Data stewards and their full-time teams make sure the quality of the information being served up in any application is accurate, complete and timely."
Second, establish internal metrics by which data quality can be measured. Those measures must cover the different dimensions of data quality, such as accuracy, completeness and relevance. Another metric should identify the rate of success: Do you want the customer contact information in your CRM application to be 100 percent accurate, or can you live with 95 percent accuracy? Keep in mind that higher rates of success carry a higher price tag. "There's a lot of information out there, so you choose your battles," Lucas says. "You may have an edict that says for customers that spend more than $20,000 per year, I expect 100 percent accuracy and completeness, and the cost of that is X."
Third, understand that data management, if it is to succeed, requires ongoing attention. It is not a finite project; it should be integrated into the standard operational flow.
5. Draining the Talent Pool
Human resources practices stemming from the heyday of the new economy have left many companies vulnerable to costly problems. In retrospect, some of the highly publicized compensation and benefits packages (pet insurance, anyone?) that companies gave knowledge workers in the late 1990s look like poor allocations of corporate resources. The recession quickly curtailed some inflated compensation packages, but many HR strategies remain out of balance.
For example, many retirement plans create what Curt Morgan, senior vice president of Mellon HR Solutions in Fort Lee, N.J., calls "retirement cliffs." Due to various levers contained in retirement package computations (e.g., portions of payouts might be tied to interest rates), employees sometimes can face a significant reduction in their payout -- up to $50,000 -- if they postpone retirement into the next calendar year. "That can cause a painful impact if an organization is in growth mode in January," Morgan notes. "And this is something that generally tends to be off the radar screen. If you haven't constantly kept your compensation and benefits programs aligned with the company's current direction, you can find that those policies encourage people to leave at a time when you very much need them to stay, or vice versa."
Another human resources transgression many companies commit, according to Morgan, is assuming that they can quickly increase staffing volumes. Most organizations cannot hire thousands of new workers as soon as the need arises. This is especially true for companies that have underinvested in HR technology.
Most human resources applications are far less expensive than finance executives expect, yet they deliver notable returns. "In the area of recruiting technology," Morgan says, "there has been a tremendous burst of activity over the last four or five years." For example, Wachovia Corp.'s executive search group uses a Web-based database of people and companies from Eliyon Technologies. This data lets the company keep the executive search function in-house "without the staggering fees of private executive search firms," notes Harry Wilson, managing director of Wachovia's executive search group in Charlotte, N.C.
Prudential recently invested in a talent management software solution from Hire.com, which enabled the financial services firm to download more than 30,000 résumés from the Web during a three-month span and boost its pool of interested candidates by 17 percent. Prudential estimates that the software saved it $195,000. Federal Express has reported similar returns from its use of Web-based recruiting services.
Morgan believes that CFOs are well- positioned to assess the efficacy of compensation and benefits strategies as well as new investments in HR technology.
6. The Hazards of WeakGovernance
Where was Enron's board? How did Tyco's former CEO play so loose with company funds? Startling questions about the quality of corporate governance have devolved into a drone because they've been repeated so often in reference to so many different organizations.
The implications of recent governance failures are both far-reaching and immediate. At an international insurance conference in Bermuda in February, American International Group Inc. (AIG) senior vice chairman Thomas R. Tizzio reported that almost 500 class action securities fraud cases were filed in 2001, more than double the 216 filed in 2000. As the leading provider of directors and officers (D&O) insurance, AIG last year recognized the problems facing the market and mobilized a road show of conferences on the topic to educate risk managers on the changing market conditions.
"For insureds with healthy balance sheets and favorable (or no) claims experience, the increases [in D&O insurance premiums] so far in 2002 range from 5 percent to 75 percent for public companies, with lesser amounts for private companies," note Fred Podolsky and Susanne Murray, executive vice president and national D&O liability practice leader, respectively, for Willis Group Holdings Ltd., a global insurance broker headquartered in London, in a D&O liability market update released in June. And the news for companies with less robust financials or significant claims experience was even less cheery. Those companies are experiencing increases in the price of their D&O premiums in the 200 percent to 400 percent range.
The long-term remedy for astronomical D&O premiums and other symptoms of weak governance mirrors the cure for lax accounting: Both require courage, integrity and decisions based on what feels right. When Kim D. Thorpe, executive vice president and CFO of FPIC Insurance Group Inc. in Jacksonville, Fla., joined the company in 1999, the board held two audit committee meetings per year. In each of the past two years, the company has held eight formal audit committee meetings. Plus, the audit committee holds private sessions with FPIC's independent auditors and the company's independent actuary. Thorpe says he's not aware of any other insurance company that follows this procedure (nor are we).
"Given the importance of reserve adequacy and particularly the significance of the reserves in our financials, we decided that doing so was appropriate and a best-in-class audit committee procedure for our industry," Thorpe says. "We also arranged for our reserves to be given a second look by an independent actuary at our independent audit firm, who's a part of the audit team. That actuary looks over the shoulder of our independent actuarial firm."
Although nothing beats fortitude for a finance executive who's trying to strengthen corporate governance, a new batch of IT applications may also help improve the quality of board oversight. BoardVantage, for example, offers a secure, Web-based communications tool that streamlines the distribution of corporate information to board members and enables online board meetings. Accenture takes that solution one step further by standardizing tools, processes and approaches that "better engage the board of directors in the process of governance," notes Boulanger. "The issue is that boards of directors have difficulty penetrating a company's real performance and operations given the traditional methods that the C suite has employed to involve them: a board meeting and a three-ring binder with 300 pages of information."
Entergy and Cinergy both have implemented Accenture's board of directors briefing book, an interactive Web-based system that provides a streamlined review process, topic-driven menus and related links. It also allows interactive note taking, highlighting and bookmarking, all of which conceivably provide an audit trail for proof of fiduciary fulfillment. Best of all, Boulanger says, the "briefing book" can be mastered by the technologically challenged in about 15 minutes. He adds, "I think we're going to see CFOs driving more effective management and governance processes through tools like this -- tools that facilitate not only the provision of information but also facilitate communication as a means to mitigate risk with regards to the board saying 'Well, I wasn't involved and I didn't know.' That's basically what happened at Enron."
7. Ignoring the Importance of Crisis Management
Other than the magnitude of its crisis, Enron is not unique. On average, U.S. companies face a crisis every four years, says L. Paul Bremer III, chairman and CEO of Marsh's crisis consulting practice in New York City. Bremer and his employees in the World Trade Center experienced a lifetime worth of crises last year. The company had 1,900 people in the two towers on Sept. 11, 295 of whom were killed in the terrorist attacks.
Bremer defines a crisis as any event or series of events that negatively impacts financial results; reputation or brand; or key relationships with employees, customers, suppliers, communities and other stakeholders. And Marsh warns clients that crises can come from any direction. Although most companies dusted off their crisis management, disaster recovery and business continuity binders after Sept. 11, Bremer asserts that many still need to be more attentive to potentially catastrophic events. Crisis management plans must be comprehensive, integrated throughout the organization, and -- above all -- flexible. "It's the unexpected crisis that levels the company," says Bremer. "Don't only think about the familiar crises."
Crisis consulting companies adhere to the belief that crisis management can be learned, regardless of whether the crisis involves the loss of employees, the erosion of brand reputation or acts of nature. Marsh works with clients on a three-phased plan to establish effective crisis-management capabilities. First, create an executive crisis team. Second, establish procedures and protocol. And third (and most often neglected, crisis management experts agree), exercise the plan regularly. The CFO should be a member of the executive crisis team. Additionally, finance executives should serve as catalysts when tying all corporate functions to an integrated, companywide communication plan. "Most plans are oriented almost entirely to outside stakeholders: the press, investors, customers," says Bremer. "You need to speak to employees and their families as well." He emphasizes that robust internal communication is the most important factor in an effective crisis-management strategy.
Developing practices to steer clear of these seven red flags can be an exercise in preemptive crisis management. Texaco was thrust into a full-blown crisis when minority employees filed a class-action lawsuit. Similarly, Cisco had to mobilize when its near-sighted inventory management practices proved ill-equipped to handle the recessionary pressures that president and CEO John Chambers likened to a 100-year flood. CFOs who help their companies avoid potential dangers now are better positioned to work through new obstacles and capitalize on fresh opportunities in the future.
They also lessen the personal stresses of doing business in the current environment. As a former U.S. ambassador, Bremer remains plugged into the national security community and is well aware of the phalanx of threats that loom over U.S. companies. After speaking at a meeting of the Austin, Texas, chapter of Financial Executives International (FEI), Bremer was asked to tap that knowledge to identify what keeps him up at night. The conference room hushed as he reflected for a moment. One hundred CFOs and finance VPs seemed to mentally run through a string of corporate nightmares: a second terrorist attack on a U.S. skyscraper, a front-page lawsuit filed by shareholder activists, another Hurricane Andrew. "Actually," Bremer responded, "I sleep well at night."