In addition to his long and impressive tenure with Columbia Business School, Professor Burton left a lasting impression in public life as well. In Washington DC, he joined the Securities and Exchange Commission as its chief accountant in 1972, then returned to New York City to become Abraham Beame’s deputy mayor for finance in 1976, a time when the city faced severe financial challenges.

The New York Times, in an obituary showcasing Professor Burton’s life, writes about his approach to accounting and financial regulation:

At the S.E.C., Mr. Burton stiffened the requirements for financial reporting by companies and lobbied accounting firms to take greater responsibility for the accuracy and clarity of the financial records under their review.

He argued that the accountant’s task should not be confined to auditing corporate books, but should include forecasts, judgments on the corporation’s financial controls and evaluations of management. And he argued that accounting firms were too secretive about their own finances.

“The mantra he was selling to Capitol Hill was, ‘An eighth grader has to understand this: Is the company healthy or isn’t it?’” said his daughter, now the general counsel for the Hearst Corporation, who was an eighth grader while her father was in Washington.

As businesses shift away from manufacturing, the value of intangible assets such as brand recognition, distribution systems and market position is increasingly important to measure. A new white paper from Professor Stephen Penman and the Center for Excellence in Accounting and Security Analysis provides new insight for firms trying to do just this.

Penman’s work, recently featured in Columbia Ideas at Work, demonstrates that the value of intangible assets can be deciphered by looking at a firm’s income statement. The first clue lies in the firm’s market-to-book ratio; a ratio of more than six indicates that the market has assigned a lot of assets that are missing from the balance sheet.

In 2008, Microsoft’s book value was $36.3 billion, while its shares were trading at $25, for a total value of $228.8 billion. … Microsoft’s income statement reported a net income of $17.7 billion for 2008. Using information from the income statement, Penman employed a simple residual earnings valuation technique to calculate the equity value of expected earnings for 2009, arriving at a share price of $23.03 — much closer to Microsoft’s share price of $25 at the time than a look at the balance sheet (absent market share, intangible R&D assets or brand) would suggest.

Penman is careful to point out that intangible assets do not operate alone — but rather in symphony with other more established assets. Take the story of Coca-Cola, for example, he says.

“Coca-Cola’s value comes not just from the brand it created, but how the brand works in combination with its distribution system. The brand is an intangible working together with other intangible ideas about how to get value from customers. What if Coke sold off its brand? All the other intangible assets, like its distribution systems, and even tangible assets such as bottling facilities — would be worth far, far less than they are with the brand intact,” Penman says. “You cannot isolate the value of individual intangibles.”

Photo credit: Anssi Koskinen

A typical Wednesday morning finds millions of online banking customers checking their balances. Unless, that is, the stock market has tanked.

When the stock market goes down, sticking your head in the sand regarding your own money and investments is not uncommon. Early research findings from Professor Nachum Sicherman, working with George Loewenstein and Duane Seppi at Carnegie Mellon University and Steve Utkus at Vanguard, show that consumers undergo an ostrich effect — giving selective attention to investment information — with their bank account balances when they see bad financial news.

In their study of 3,000 consumers at a regional U.S. bank, Sicherman and his colleagues found that when the market goes down, so does online balance checking. On average, a one percent rise or fall in the stock market increases or decreases, respectively, the likelihood of a customer logging into his or her bank account by one percent. Additional preliminary results taken from the data of one million customers at Vanguard are consistent with this outcome, says Sicherman.

Initial results show that individuals with larger balances, especially those with higher percentage of stocks, check their balances more frequently. Women, for example, go online less than men, and the ostrich effect is stronger for men than for women. Their data also showed that Wednesday has the peak number of account logins and people tend to check their balance between 9 a.m. and noon.

Sicherman and his co-researchers are looking at the results to see if there is a link with patterns of trading.

“To what extent does the ostrich effect affect trading if people are reluctant to look at their account for psychological reasons when the markets go down?” says Sicherman. “The next logical thing to hypothesize is that if they are not looking, then they are trading less. But we don’t have an answer yet.”

Photo credit: Njitram lexe Nav

Read the previous post

The debate over fair-value and mark-to-market accounting rules has quieted down in recent weeks but it is far from over. At the heart of the issue is this question: Are hard-to-value securities worth only what the market is willing to pay, or is the market too dysfunctional to set values in a meaningful way?

A new paper, “The Subject Matter of Financial Reporting: The Conflict between Cash Conversion Cycles and Fair Value in the Measurement of Income” published by the Center for Excellence in Accounting and Security Analysis, challenges some basic assumptions in the existing model for financial reporting. (The paper was reportedly circulated among the financial regulators responsible for the recent rule change.) Authored by Andreas Bezold, a former chief risk officer and deputy CFO/board member of a large German Bank, and reviewed by Professor Trevor Harris, the paper concluded that a clearer distinction between fair-value changes as information and fair-value changes as income is essential. The paper makes these key points:

•Business activity is the primary object of financial reporting, which is characterized as investing cash in non-cash resources to be combined according to a specific economic logic to generate future net cash flows. The production of net cash flows is the business activity in its entirety, not single non-cash resources or constructs like “net assets”.

•Different business activities have different business models based on a different economic logic and that the value of a non-cash resource to an activity depends on the way it contributes to the net cash inflows under the economic logic of the activity in progress, i.e. depending on its function and use.

•Accounting concepts and measurement attributes have to be aligned with the inherent economic logic of an activity if faithful representation is to be achieved.

Click here to download the complete paper (PDF).

Photo courtesy of CEASA

The Credit Cardholder’s Bill of Rights, which was signed into law on May 22, is the first major overhaul of credit card regulation in 30 years. Is the bill a game-changer for the way consumers use credit or the way lenders dole it out? We spoke with assistant finance professor Enrichetta Ravina, who has done research on the credit card industry and consumer behavior, about the relationship between the lenders and borrowers, how it might change, and whether credit cards make us happier.

Now that credit card holders have a bill of rights, how might that affect consumer behavior?

1. Better debt management More transparency in the credit card terms could mean that consumers are more informed and better understand the terms of their credit card contract. They might avoid paying fees due to their inattention/misinformation and to switch to cheaper forms of credit if they need to borrow. The caveat is that more information doesn’t always lead to restraint. In the same way that knowing that fats are unhealthy doesn’t make everybody restrain from fast food, it is unlikely that being better informed on the terms of the credit card contract will make everybody manage their debt more carefully.

2. Prevent early onset debt New restrictions for issuing cards to people below 21 will make it harder for students and very young consumers to have easy access to credit. The legislation is aimed at protecting a category that might be less financially educated, has fewer incentives to be financially responsible and preventing that they become overwhelmed by debt even before starting their working life.

3. Harder to get easy credit The new legislation requires credit card companies to wait until the account is 60 days late before applying a penalty interest rate and to give 45-day advance notice before changing the interest rates or any other terms. Thus, the credit card companies’ pricing strategy will change. A better ex-ante assessment of the creditworthiness of the consumers will be necessary and credit card contracts will have lower credit limits, higher interest rates for certain categories of consumers and more upfront fees. Lower credit limits and higher interest rates will make it harder for overly optimistic, financially uneducated consumers to get into unmanageably high levels of debt.

What does a consumer’s spending say about his or her behavior?
Most consumers are very predictable in their credit card use. In my research I find that consumers exhibit a high degree of habit in their consumption choice and that they prefer a smooth, increasing consumption path. Demographics like gender, age and income bracket are important, but mostly people’s spending on catalog and online shopping and on other credit cards are the best predictors of their behavior and of whether he or she will carry a balance, pay late or always be on time.

Who are credit card companies making money from?
The most profitable consumers for a credit card company, and therefore the most sought after, are those that spend a lot, pay late and carry a balance (which 45% of Americans do). People’s attitudes to money and their finances tends to be remarkably consistent across financial instruments and therefore people that miss payments on other credit cards and auto loans, stretch themselves with high loan-to-value mortgages are more likely to do the same on this card. Among these very profitable consumers, however, are those that “hide” and who will generate charges only for a short period and will soon default.

Can credit card companies tell who might default from their spending behavior?
It is very difficult to predict this behavior early in advance. These consumers that are very risky are those with limited financial education. Such consumers do not understand the terms of the credit card contracts, are not good at budgeting, saving and spending within their means. At the beginning, they are very profitable for the credit card companies because they generate fees and interest charges. However, once an income shock hits them, or their spending habits get out of control, they rapidly become the worst type of accounts.

What is the upside to easy credit?
Credit cards constitute a tremendous opportunity for some consumers and are very important for economic growth. They allow entrepreneurs to finance the very first stages of their companies when it is hard or impossible to get a loan from a bank. They also allow households to finance durables, consumption goods and other projects. For these reasons, they promote economic activity and a more efficient allocation of economic resources. Compared to other countries where credit cards (and debt) are less diffused, U.S. consumers face more dangers, but also more opportunities and more means to fulfill their projects.

Does this greater opportunity and means to fulfill projects translate into more happiness?
In my research I find that happiness is a relative concept. Above a certain level of consumption that satisfies the necessities of a comfortable life, happiness doesn’t depend on the amount we consume, but rather on the amount we consume compared to the people around us. The reference group we belong to are work colleagues, neighbors, people with a similar socioeconomic status to which we tend to compare ourselves. Credit cards can be used to consume more than the reference group (even though the income is not enough to cover spending), in the hope that income will continue to grow or that no emergency comes to disrupt this fragile equilibrium. Such a use of the credit card is usually associated with short-term happiness and economic problems and anxiety down the road.

Photo credit: Andres Rueda Lopez

On Thursday the Treasury announced their choice of executive pay overseer, Kenneth R. Feinberg, who will have the task of setting compensation of the top 25 executives at seven financial firms. The new appointment challenges the view that it is not what you pay, but how you pay, that matters, says accounting professor Sudhakar V. Balachandran.

“What we have seen to date tells us that reforms in how boards set compensation are warranted, and that there needs to be a better relationship between pay and performance, particularly performance that is not immediately observable, ” he says.

“That said, it is a completely different matter to say that a centralized body in Washington D.C. can do this better, ” Balachandran continues. “Boards have substantially more information about the company and its circumstances and by centralizing the process we might be throwing away a lot of valuable information. There is a difference between providing reform to the compensation process and providing a centralized compensation policies that are determined by a political process. I believe only the former has a chance of success but I’m afraid we may be heading towards the latter. ”

Photo credit: Michael Aston

Their imprisonment is nearly unprecedented in the purview of corporate accounting scandals. Hence, some view it as unfair that they must await trial in prison. However, their imprisonment must be seen as part of a system of action that is seeking to preserve investor confidence and limit the collateral damage of Satyam’s ruin. It also underscores the importance of accountability by independent auditors. The auditors were responsible for pro-active audit work which they, by their own admission, did not conduct. Indeed, the defense of, “No concerns were ever brought to us by anyone…,” which the Satyam Auditors gave in the Times article, rings a bit hollow for me.

In 2007, the audit committee of Satyam, and ultimately the shareholders, paid the auditors $873.9 thousand in audit fees and $1.802 million in total fees including fees for tax and other non-audit services. In 2008, they paid $1.172 million in audit fees and $1.918 in total fees. These fees are paid for the auditor to “audit” actively, not passively. Auditors typically do not wait for concerns to be brought. They investigate independently and to a set of professional standards, and so the imprisoned auditors’ claim of innocence by inaction is implausible given the makeup of the assets on Satyam’s balance sheet. Consider the assets reported on Satyam’s 20-F filed on March 31, 2008:

	As of March 2008	As of March 2007
Cash and cash equivalents	290.5	152.2
Investments in bank deposits	826.7	--
Accounts receivable, net allowance for doubtful debts	508.4	364.2
Unbilled revenue	81.5	38.6
Deferred income tax assets	23.7	17.1
Prepaid expenses and other receivables	131.7	37.1
Total current assets	1,862.5	609.2
Investments in bank deposits	--	767.6
Investments in associated companies	4.7	4.6
Premises and equipment, net	236.6	163.1
Goodwill, net	80.0	32.7
Intangible assets, net	15.6	7.4
Other assets	43.9	39.5
Total assets	2,243.3	1,624.1

Two numbers are important. First, cash (and cash equivalents) and second, investment in bank deposits (short term in 2008, and long term in 2007). These accounts are approximately 52% of the balance sheet in 2007, and approximately 49% of the balance sheet in 2008.

Roughly half of Satyam’s balance sheet was either cash (which is typically held by its bank) or a bank deposit (similar to a certificate of deposit that any of us may hold at our local bank). Given the large holding of these assets I find it hard to believe that the auditor could be paid in the ballpark of one million dollars in audit fees and then not proactively investigate the details of half of the balance sheet. It’s also hard to believe that they did not look at these accounts given how easy cash and bank deposits are to audit.

Typically one audits cash and deposits by contacting the bank to get a statement with the company’s account balance and then compares the statement to the balance sheet. If the two amounts match then the auditor offers an opinion that account has been stated accurately, confirming that the company indeed has the money it claims to have on its balance sheet.

Satyam’s auditors claim that they relied on bank statement documents provided by the company, which ultimately turned out to be false statements. This is not a typical practice among auditors in India who instead independently ask the bank to provide statements directly. It is further shocking that Satyam’s auditors did not pursue independent verification given the unusually large holdings of cash and deposits on the balance sheet.

The auditors also argued that there were many bank accounts and that made independent verification more difficult. But the number of accounts should have been a tip-off. If you are company like Walmart, with stores covering many locations that do a lot of daily cash business, you need to be banking with many banks and accounts so that each store can get cash to the bank quickly.

In contrast, at a professional business service firm like Satyam, clients pay by check or electronically, and payments are processed in a centralized system and so there is less need for numerous bank accounts. A seasoned accountant with 31 years of experience (which Satyam auditor Mr. S. Gopalakrishnan had) would know this, and should have raised a red flag. They should have taken more initiative.

An audit is part of what an accounting firm calls an “assurance” service, and it is hard to provide assurance if auditors don’t occasionally challenge company management and seek independent verification.

Photo credit: nav in atl

In a recent column for Slate, Professor Ray Fisman argues that the process of how executive compensation is determined — namely the practice of peer-pay comparison — has allowed the pay of top-level employees to snowball. Fisman suggests that the priority for pay must be realigned with performance. He writes:

… the lesson isn’t that we should dump the baby of peer comparison out with the bathwater. If CEOs and others should earn “what the market will bear,” how better to figure this out than to look at how the market is treating other CEOs? But this CEO labor market will work only if all companies also keep an eye on the more basic market principle that higher CEO pay must first and foremost be tied to the success of the companies they lead.

Accounting professor Sudhakar Balachandran argues that another potential effect of the peer-pay model is decreased sensitivity of pay-to-poor performance (see blog post “Paying for a Pulse”).

“Peer-pay comparison is typically motivated by the goal of trying attract and retain the best talent, which is often at odds with the other major goal in compensation, that of motivating performance,” says Balanchandran. “Businesses are trying to achieve multiple objectives that are conflicting with each other, and that tension has to be managed and resolved by the board.”

Balanchandran suggests that the balance for determining how to structure executive pay — where a firm must find and retain talent on one hand and motivate leaders on the other — creates a tension that is never likely to disappear. Recognizing and accepting that push-and-pull may be the first step for creating a new model for pay, he says.

“Some of the populism found in the business press these days is a little dangerous because it tries to pretend that tension doesn’t exist. And that can create a bigger problem because you are ignoring real economic tensions.”

Photo credit: Thomas Claveirole

At Friday’s community forum, Professors Paul Glasserman, Trevor Harris and Hitendra Wadhwa (pictured at right) held an open discussion with students about how best to move forward from the financial crisis. The forum covered economic issues ranging from risk management to accounting to the importance of not allowing the near-constant stream of negative news to affect your decision making.

Professor Glasserman began the event by speaking about capital requirements for banks as they relate to the banks’ risk management practices. He offered three main points:

1. Tightly linking capital requirements to risk can lead to dangerous procyclical behavior

   “When a bank’s assets start to look more risky [as a result of a downturn], it must hold more capital. How does it hold more capital? It cuts back on lending. So at the worst possible time, there’s an incentive — in fact, a requirement — for banks to cut back on lending.”

   To help prevent this, Glasserman suggested that banks take countercyclical measures, such as averaging out their risk over the business cycle. He also recommended that banks be required to hold additional capital in good times so that in down times there’s a buffer for them to draw on.

2. Banks should continue to bear the responsibility of regulating their own risk
   

   While it’s understandable that the recent trend of forcing banks to regulate their own risk has received a lot of criticism, Glasserman said, putting the burden back onto regulators might make matters worse.

   “If you go to an environment where the regulators are specifying a very precise set of rules, you’ve created an enormous incentive for banks to manufacture products that look low-risk by regulators’ standards but are in fact high-risk in all the ways the regulators haven’t anticipated. And that’s a large part of what’s led to the current crisis.”

3. Systemic risk must be factored into capital requirements
   

   “A traditional view of risk management says, ‘What harm can the market do to me?’” Glasserman said. “When you ask about systemic risk, you’re asking, ‘What harm can I do to the market?’ It’s a fundamentally different approach, and it’s not been part of the way capital standards have been set to date.”

Professor Harris referred to the situation described by Glasserman as a “classic accounting problem.”

Harris spoke about a critical flaw in the subprime mortgage-backed securities that are a big part of the crisis, is that all parties (originators, intermediaries, investors, rating agencies and auditors) lost sight of the underlying fundamentals of people who had borrowed more than they could afford.

“My whole view is that people have forgotten fundamentals, and they’ve created lots of quant-based analytics that actually have nothing to do with reality,” Harris said. “What that leads to in many cases is the illusion of precision. We have so many techniques, including valuation techniques, to come up with point estimates, and the reality is that there’s huge amounts of uncertainty going forward, and we have to deal with that.”

He concluded, “I view [the crisis] as a great opportunity to fix a lot of systemic problems. My biggest fear is that if we come back too quickly, we won’t actually address a lot of these issues. If we don’t deal with complexity and address these fundamentals, we will actually end up in a much worse situation.”

Professor Wadhwa said that while it’s easy to allow the near-constant stream of negative economic news to affect your mood, doing so can impair your ability to make critical decisions.

“[Maintaining a positive outlook] broadens your mind, making you more aware of the periphery of whatever it is you’re looking at. It makes you more mindful of a whole range of ideas.”

To support his position, Wadhwa cited research that demonstrated a link between the mood of physicians and their ability to properly diagnose patients.

To keep yourself in a positive state of mind, Wadhwa suggested taking the following steps:

1. Break the causal link between external events and your internal mood. Do this by injecting behaviors, such as displaying gratitude.
2. Use humor and body language to project a positive mood not only outward but also inward.
3. Turn adversity into transformational opportunities.

“Even with the constraints many of us face,” Wadhwa said, “there’s a potential for us to ask ourselves, ‘What is there within this that might be redemptive?’ By the fact that certain doors might have closed on us, we are forced out of our comfort zone to think anew about our skill set and interests and who we are.”

Photo courtesy of Columbia Business School

The massive accounting scandal involving Satyam, one of India’s largest outsourcing companies, seriously hurts investor confidence, not only in India but worldwide, says Professor Sudhakar V. Balachandran.

“They should have been under good accounting scrutiny, and so this is shaking confidence,” Balachandran said in a phone interview Thursday morning. “There will be spillover effects, people will think twice about investing in Indian tech companies, investing in India and, following that, investing in the market. It’s the old story of a few lemons corrupting the entire market.  If you can’t tell the good from the bad, it just becomes too risky to invest. Eventually that poses risk to the entire economic system.”

In an op-ed published on Forbes.com on January 8, Balachandran says that the three mechanisms to prevent fraud — corporate governance, audits and legal consequences — are not doing enough.

The company’s good social standing added another layer of complexity. “[Satyam] was well run and well governed.  They also did a lot of charitable work in rural development in India, so they appeared to be taking social responsibility seriously. They did a couple little things with their accounting early and then it snowballed,” said Balachandran. “These may not have been evilly intentioned guys; they had a history of doing good.”

Especially worrisome to Balachrandan is the failure of the requirements for auditing control systems.

“Satyam has an ADR [American Depository Receipt] and they are listed on the NYSE, so they have to follow American rules similar to those of American publicly traded companies. That includes having audited financial statements, using US GAAP, having signatures from the CEO and CFO stating that their accounting is sound as required by Sarbanes-Oxley Section 302, and so on. With all this, the company reported a lot of cash — a little more than $1 billion — that wasn’t there,” he said.

“Section 404 of Sarbanes-Oxley has very strict and very costly rules on what should be audited in the firm’s internal control systems. Auditors certify the controls so we can believe that the company is not recording fictitious transactions, so that when they say they have made a sale, we can believe they actually made a sale. In addition, auditing standards in India are not trivial and definitely require the auditing of cash. The fact that they didn’t catch the missing cash [at Satyam] raises a lot of questions.”

Prof. Balachandran acknowledges Columbia Business School professors Ray Fisman, Bruce Kogut, Partha Mohanram and Amir Ziv for their contributions in the analysis of the Satyam situation.

Understanding the financial underpinnings of mortgage-backed securities, the investments at the center of the financial crisis, is a difficult task. The complex structure of these investments may have even obscured their inherent risk to those parties directly involved with their purchase and sale.

A December 7 New York Times article by Gretchen Morgenson chronicles the predicament of Moody’s, the credit rating agency that has fallen under scrutiny for inaccurately giving high ratings to many mortgage-backed securities, including those with questionable financial fundamentals.

The rating agencies, however, were not alone in their misjudgment. According to a recent article by Professor Trevor Harris in Ideas at Work, all parties to the transactions — including the lenders, mortgage brokers and banks, securities firms and borrowers — failed to understand the fundamentals of these investments.

According to Harris, “[They] were making a bet on constantly rising home prices, while disregarding the real people and real homes on top of which these products were precariously built. Much like a Ponzi scheme, everyone lent to everyone else, creating a bubble and then compounding it. Returns could only continue while new money kept flowing into the system. When the money stopped, the whole system started unraveling.”

Harris suggests that by bringing transparency into the underlying fundamentals and risk characteristics of a business, regulators will be able to provide a more accurate and complete assessment of the related fundamentals and risks.

For a more detailed look at how the fundamentals of mortgage-related investments were neglected and what can be done to prevent this from happening again, see Harris’s article, “Back to Basics,” in Ideas at Work.

In recent years, compensation packages for CEOs and other senior corporate executives have been criticized for both their high level and their growth, often despite poor company performance. Are patterns such as this likely to continue in the aftermath of the recent financial meltdown?

You might think the answer would be obvious. For one thing, the precipitous drop in the stock market reduces the value of stock options, typically the largest component of executive compensation. Even companies that have a history of granting a fixed value of stock options may be unable to continue the practice.

“It may simply be too dilutive to grant the number of options required to maintain fixed value,” says Irv Becker, managing director of the compensation consulting firm The Hay Group, in New York. Second, current economic conditions are likely to depress corporate earnings, which are commonly used to determine incentive-based bonuses. Third, executive compensation packages are designed to attract and retain the best managerial talent, so an executive being recruited by company A is likely to be “made whole” for any compensation that he or she might lose if they leave company B, including unvested stock options. Since the current market is likely to leave many previously granted options “under water,” the cost of attracting and retaining employees is likely to decline.

In other words, when we “pay for performance,” if performance is down, shouldn’t pay go down with it? In theory yes. But many of my academic colleagues and I have observed a very robust pattern in executive compensation over the years that we like to call “pay for pulse.” The pattern is as follows: Suppose we split all companies into two groups: Group one, in which shareholders saw some positive returns to their investment for the year, and group two, in which returns were negative. As you might expect, the executives in group one receive compensation that is greater, with better returns corresponding to larger increases in compensation. So in group one we observe “pay for performance.”

In contrast, executives in group two typically also receive more in compensation, despite their poor performance. Historically this increase has been more than double the rate of inflation in most years. What’s even more troubling is that there is typically no difference between pay for executives in firms with marginally poor performance compared to those in firms with worse performance. Hence the term “pay for pulse.”

What’s driving this?

When performance is poor, the company’s board of directors and its compensation committee face the difficult task of separating the role of the economy from the contribution of management. So when the economy is bad, boards may be tempted to conclude that their management team did a great job given the circumstances. Typically boards rely on two mechanisms to reach such a conclusion.

First, compensation committees typically benchmark their company’s compensation and performance with that of a peer group. Correspondingly we see better compensation in firms where the board concludes that the company has outperformed its competition. Second, executive compensation typically allows the inclusion of subjective assessments of factors such as leadership, which are difficult to measure objectively.

Are there reasons to believe that “pay for pulse” will go away?

I think so. The revised compensation disclosure requirements enacted by the Securities and Exchange Commission (SEC) in 2006, combined with the observed growth in shareholder activism in recent years, is likely to reign in the board’s use of peer groups and subjectivity in awarding compensation. With broader disclosure, shareholders have substantially more information from which to form opinions of the fairness of their company’s executive compensation. For example, companies must disclose the peer group that they used in the compensation process, so shareholders can form their own opinion on whether a reasonable peer group was used or whether the board “cherry-picked” the peer group to justify higher compensation.

Even before the economic meltdown reached its peak, we began seeing examples of the effectiveness of the SEC’s regulations and the actions of shareholders. Specifically, a survey of executive compensation in 2007 by The Hay Group showed — for the first time in recent history — decreases in compensation when firms had decreases in stock price. In prior years, we typically observed small increases in compensation for firms when stock price decreased, and larger increases in compensation as stock price increased.

In addition, we recently began to see firms take steps to curtail “golden parachute” severance packages. Finally, in 2007 we saw the growing use of “claw backs,” which permit firms to take back the portion of compensation that was awarded to executives using misstated accounting numbers.

Overall, the executive compensation process is shaped by many forces, but in our current environment scrutiny from both regulators and investors is particularly high. The rescue of Fannie Mae and Freddie Mac, and the $700 billion federal financial rescue package, impose executive compensation restrictions including the elimination of golden parachutes and provisions for claw backs.

But as you might expect, there are efforts underway to negotiate exceptions to these compensation restrictions. Will our current economic meltdown, combined with regulatory scrutiny, shareholder activism and increased disclosures, eliminate “pay for pulse” going forward? Let’s hope so.

This column also appeared on Forbes.com.

While everyone is looking for reasons why this nation is in a financial mess, let me toss another one into the ring. We’re in this situation because we’ve focused almost exclusively on the income statement and ignored the balance sheet.

An income statement indicates how revenues are transformed into net income, or profits after taking expenses into account. The balance sheet lays out the assets deployed in the operations to generate the revenues that drive profits. The critical factor for any firm’s success is its profitability, i.e., how much profit is the firm making relative to the amount of assets that have been deployed. Almost no one looks at profitability — we focus on raw profits instead, to our detriment.

Who’s “we”?

It’s the manager chasing growth in sales and earnings, without worrying about the resources used to obtain the growth.

It’s the financial analyst who incessantly focuses on Earnings Per Share (EPS) targets without any concern for whether the targets were met by organic growth or by value-diminishing acquisitions.

It’s the investment banker who spends most of his attention on whether a transaction is going to be "accretive" or "dilutive" to EPS, not on whether the transaction is going to improve asset productivity.

It’s the business media, which focus on these flawed metrics and increase the pressure on managers to meet rising earnings expectations, even at the cost of declining profitability.

It’s investors who focus all their attention on whether the firms meet analysts' estimates, harshly penalizing firms that miss by a few cents.

It’s the board of directors who compensate managers based on earnings targets instead of profitability targets.

It’s the regulators who have permitted firms to park many of their toxic assets off the balance sheet.

And it’s all of us in business academia for not properly explaining to our students that profit growth and profitability growth are not the same; in fact they are often opposites.

What happens when one ignores the balance sheet? First, one ignores the quantum of assets deployed for the generation of income. Consider Lehman Brothers and other firms that increased their profits quite dramatically until last year through investments in mortgage-backed and similar assets. Their profit growth was dramatic, as was their stock price performance, almost doubling from $44 at the start of 2005 to around $80 in June of 2007. However, if one considers the growth in the amount of assets on their balance sheet, the trend in profitability is much more modest.

Second, one ignores the quality of assets on the balance sheet. If one had paid attention to the rising profits from these risky investments with one eye on the balance sheet, one might have had a better appreciation for the nature of the risk involved. Of course, regulators made this worse by allowing firms to place many of their assets (such as Variable Interest Entities (VIEs), which are at the heart of the subprime mess) off the balance sheets. When people ignore what’s on the balance sheet, what are the odds that they’re reading the footnotes to see what’s left off it?

What does paying more attention to the balance sheet imply? Managers should care as much about what any new transaction brings to their balance sheet as what it brings to their income statements. Analysts should stop focusing exclusively on EPS targets and also forecast profitability targets. Investment bankers should abandon the charade of “accretion-dilution” analysis and focus on whether an M&A transaction really adds economic value (historically, most do not, and my guess is this is partially driven by ignoring the balance sheet).

The business press should stop facilitating the negative cycle caused by an emphasis on profits and growth without regard to the assets used to derive them. Boards of directors should reward managers for growth in profitability, not profit, by incorporating measures such as residual income (earnings less a charge for capital employed) in deciding executive compensation. Regulators should clamp down on off-balance sheet items, a lesson that apparently wasn't learned from the Enron debacle. Finally, business academics must train the next generation of managers, financial analysts and investment bankers to understand the critical difference between profit and profitability.

With any crisis, there is always a period of increased scrutiny, followed by business as usual. In this case, I hope all the “we’s” listed above continue to pay greater attention to the balance sheet once this crisis has been resolved.

This column originally appeared on Forbes.com on Oct. 5, 2008.

Photo credit: Dan Foy

Some large American companies may begin using international accounting standards, perhaps as soon as next year. The move comes after the Securities and Exchange Commission voted last week to propose a “road map” for the conversion to international accounting rules. The decision could require all American companies to be on board by 2016.

The SEC’s vote pushes the global business community toward a single set of standards, which could make it easier for investors to compare international companies and make it easier for firms to raise capital.

“Chairman Cox and the commissioners should be congratulated on this bold but appropriate move,” said Professor Trevor Harris, whose research focuses on U.S. and international accounting practices. “The move will be beneficial for investors and corporations as the IFRS are sufficient and of a high quality and we will be more aligned with the rest of the world.”

However, there are concerns about how easily American companies can learn the new rules and the how uniformly the rules will be applied.

“While there are some who will try to denigrate the move, research I did in the mid-1990s indicated for practical purposes the IAS was good enough even then,” said Harris. “This move was in many ways overdue.”

Once upon a time risk management was a highly technical discipline of interest mainly to risk management professionals, but over the past decade it has become a topic of great interest, particularly among managers, investors and regulators. And recent economic news has put an even bigger spotlight on the profession.

Of interest to me is how, and how well, risk management information has been making its way into governance frameworks of companies, and I had the chance to hear firsthand about this when I was at an assembly of large company chief risk officers in October 2007. The topic of my discussion was how risk management organizations (RMOs) and boards of directors interact — and it was clear from the group interaction that top-level practices differed extensively.

So as a followup to that assembly, my colleague David R. Koenig, the former chairman of PRMIA, and I conducted a survey of very large corporations around the world, and the results confirmed that a standard of best practices for employing risk management within a governance structure does not yet exist.

Our survey results also confirmed something else: there is substantial change occurring within governance structures toward a more robust incorporation of risk management. And we found that while some companies employ ongoing efforts for the communication and improvement of governance and risk management practices within their board and employee populations, a very substantial number of others do not have such capabilities in place.

Our survey shows a wide variety of approaches currently being used to facilitate interactions between RMOs and boards — even within the same industry — and that meaningfully different approaches to risk/governance implementation exist at many levels in the companies: at the board committee and executive level, in the chains of reporting within the executive suite and in patterns of communications to governance structures.

Not surprisingly, an audit committee is the most frequent choice for board oversight of risk management, but still was the choice of less than one third of our survey respondents. The remaining choices span a wide range of board entities. Risk committees are emerging as an important board-level committee, but they only accounted for 17 percent of the risk oversight assignments reported to us. There are many factors that can account for this wide dispersion of choices, but it certainly suggests that the board of directors interface with the risk management organization is far from settled into a widely acceptable pattern, and the relationship will continue to evolve.

We asked participants about their objectives for risk management and found they also differ even between participants in the same industry and are almost always multifold. Most of our survey participants agreed on loss avoidance and control as objectives, while a smaller number — but still a majority of respondents — also identified securing a competitive advantage as an objective.

Finally, we found the most significant task lacking with many (but certainly not all) of our survey group was effective communication and education on risk policies for employees, a surprising gap in this important element of good governance practice.

It’s clear that further study of means for effective communication of the corporate appetite for risk, risk policy and risk data/reporting expectations is warranted to ensure that firms are creating the kind of effective culture that boards are increasingly seeking to foster. And if there is an expectation that employees are engaged in best practice governance and risk management, it must be modeled and communicated from the top to be achieved.

The full study is scheduled for publication by Wiley-Blackwell later this year in their monograph series, “Corporate Boards: Managers of Risk, Sources of Risk.”