Roles and Responsibilities of Management

Chapter VI

Chapter Objectives: • Introduce the managerial function of corporate governance.

• Understand the roles, responsibilities, and duties of corporate senior

executives, including the CEO and CFO.

• Identify the components of executive compensation and illustrate how

each of these components relates to effective corporate governance.

• Identify the financial reporting requirements of public companies and SOX

provisions that pertain to management certifications of financial reports and

internal controls.

• Be aware of financial reporting challenges facing public companies

including off balance sheet arrangements, aggregate contractual

obligations, and critical accounting policies and practices.

• Discuss management’s responsibilities for ICFR.

• Provide an overview of the costs and benefits resulting from Section 404

compliance.

Key Terms Chief audit executive (CAE)Chief risk officer (CRO)Corporate development officer (CDO)Enterprise risk management (ERM)EXtensible Business Reporting Language (XBRL)Financial Accounting Standards Board (FASB)Institute of Internal AuditorsResearch FoundationInternational Accounting Standards Board (IASB)International Financial Reporting Standards (IFRS)Joint Committee on Taxation other postemployment benefits (OPEB)tax shelter

Management Responsibilities Operating Process. The operating process entails: (1) operating activities of designing products and services, marketing and delivering products, invoicing products, and servicing customers; (2) investing activities of investing in both human and capital resources; and (3) financing activities of funding investments and expenditures through internal growth, issuing stocks, or incurring debt.

Financial Reporting Process. Management should report both financial and nonfinancial KPIs that assist investors to predict the company’s future cash flows from operating, investing, and financing activities.

Compliance Process. The compliance process involves compliance with all applicable rules, regulations, laws, and standards, including regulatory, legal, tax, environmental, social, and ethical standards and best practices.

Corporate officers CEO.

CEO faces some challenges, including: (1) fiduciary duties (including duty of loyalty and duty of care) (2) self-serving and self-dealing, (3) succession planning, (4) Duality (please refer to chapter 4), (5) financial knowledge and understanding.

The role of the CFO consists of both strategic performance and reporting compliance activities.

Corporate development officer’s position is especially important for the companies which are actively involved in merger’s and acquisitions process.

CEO

CFO

CDO

Chief Risk Officer is a part of Enterprise Risk Management (ERM) framework. So, in the post-SOX era CRO doesn’t only have to identify and control risk, but also has to identify growth opportunities.

A keen focus on internal control in the post-SOX period has necessitated companies to centralize their compliance efforts with internal control requirements. One way to synergize the compliance activities is to establish a new managerial position of the chief internal control officer (CICO) or to strengthen the existing position of CCO.

Corporate officers CRO

CICO

Executive Compensation Components of Executive Compensation.

1. Salary2. Annual Incentive compensation (bonus) 3. Long-term incentive compensation4. Stock options award (those should be recognized as expense in the

income statements according to the provisions of SFAS No. 123(R))5. Employment contracts, severance, and change-of-control

payments6. Retirement arrangements7. Stock ownership.

Executive Compensation Disclosure - On July 26, 2006, the SEC approved comprehensive changes in the disclosure requirements and to

comply with these requirements, companies should provide greater disclosure in their proxy statements, annual reports, and registration statements regarding total compensation of their directors, principal executive officer, principal financial officer, and three highest-paid

officers.

Financial Reporting Requirements

Public companies with more than $10 million of assets whose shares are held by more than 500 investors are required to file auditor’s annual reports (Form 10-K or 10-KSB) and quarterly reviewed reports (Form 10-Q or 10-QSB) with the SEC.

The annual report of public companies normally contains the following financial information:

1. Audited financial statements, including their notes2. MD&A of financial condition and results of operations3. Management certifications of financial statements and internal controls4. Management’s assessment of the effectiveness of ICFR5. ACR6. Independent auditor’s report on financial statements7. Independent auditor’s report on the effectiveness of ICFR8. Five-year summary of selected financial data9. Summary of selected quarterly financial data for the past two years10. Quarterly market data for the past two years, including high and low stock prices for common stock, dividends paid, and price earnings ratio.

Section 302

Small Reporting Companies

The SEC proposed its principles-based rules for smaller companies for so-called nonaccelerated filers — companies below the $75 million market capitalization.

Financial Reporting Requirements

Financial Reporting Challenges Off Balance Sheet Arrangements Disclosures.Amendment adopted in January 2003 by SEC requires a company to provide an explanation of its off balance sheet arrangements in a separately captioned subsection of the MD&A section of disclosure documents filed with the SEC.Aggregate Contractual Commitments.Public companies, particularly accelerated filers (market capitalization of more than $75 million), are required to disclose their annual reports filed with the SEC in a table with their aggregate amounts of specified categories of contractual obligations shown on a yearly basis.Disclosure of Critical Accounting Policies. Public companies are required to provide the following disclosures for each of the identifiable critical accounting estimates in the MD&A: (1) description, (2) significance, (3) sensitivity analysis, (4) historical changes, (5) communication to audit committee, (6) identification of segments, (7) segment-specific effects.

Initial Adoption of Accounting Policies. The initial adoption of accounting policies is required when economic events and business transactions (1) occur for the first time and have a significant effect on the company’s financial presentation, (2) become material that were previously considered immaterial in their effect on the company’s financial reporting, and (3) occur that are significantly different from previous events and transactions.Disclosure of Changes in Existing Accounting Policies.SEC rules and accounting standards require public companies to disclose changes in their existing accounting policies and practices.Acceleration of Periodic Report Filing Dates and Real-Time Disclosures. Section 409 of SOX authorizes the SEC to issue rules requiring companies to make public disclosure of their financial information on a “rapid and current basis.”

Financial Reporting Challenges (Cont)

Non-GAAP Financial Measures.The SEC in January 2003 issued rules and amendments toaddress public companies’ disclosure or release of certain financial information that is presented on the basis of methodologies other than GAAP. (Recognition G) Voluntary Changes in Accounting Policies.SFAS No. 154 requires companies that make a voluntary change in their accounting policies to apply the change retrospectively by revising prior years’ financial statements rather than showing the cumulative effect of accounting changes as one lump sum.Accounting Pensions and Other Postemployment Benefits. FASB issued SFAS No. 158 (September 2006), Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, which requires companies to recognize on their balance sheet the funded status of their pension and OPEB plans as of December 31, 2006, for calendar year companies.

Financial Reporting Challenges (Cont)

Principles-Based versus Rules-Based Accounting Standards. The SEC’s study recommends a hybrid of focusing on an “objectives-based” approach in establishing accounting standards.Conceptual Framework for Financial Reporting.FASB and IASB - new conceptual framework project.

Financial Reporting Challenges (Cont)

A hierarchy of accounting qualities

Earnings ManagementEarnings management is made possible and is often legitimately accomplished within the flexibility of GAAP rather than through noncompliance with GAAP.Financial Restatements.

Number of companies who filled restatements

Financial Reporting Challenges (Cont)

Convergence in Financial Reporting

The development of IFRS is now considered one of the most commonly used accounting languages worldwide. Convergence of IFRS and U.S. GAAP should benefit the global capital market primarily because such convergence reduces the differences in global accounting policies and practices

Financial Reporting Challenges (Cont)

Internal Control Reporting and Executive Certifications

SOX and SEC-related implementation rules require public companies to design and maintain effective internal controls and disclosures for assessment and reporting of their disclosure controls and procedures and ICFR.

Internal Control Variations

Internal Control Over Financial Reporting

1. Management responsibilities under Section 302 of SOX.2. Management responsibilities under Section 404 of SOX.

The CEOs and CFOs of small- and medium-size and foreign companies still certify their ICFR under Section 302 of SOX for their 2004–2005 filings and onward. However, the SEC has postponed Section 404 compliance for smaller companies (market capitalization of less than $75 million) and foreign companies to their fiscal years ending on or after December 15, 2007.

Section 404 requires management and auditors to test and report on the effectiveness of internal controls above and beyond the requirements of Section 302.

Section 404

Section 404 Costs

the actual cost of auditing ICFR is in the range of $1.5 million to $10 million, with an average of $2.6

million for Fortune 1000 companies

Benefits of Section 404 Compliance

The expected benefits of compliance with Section 404 are (1) more investor

confidence in financial reports, (2) more accurate and reliable financial reports, (3)

more financial fraud prevention and detection, (4) more effective ICFR that

improves operating, investing, and financing activities, and (5) lower cost of

capital.

Sustainable Section 404 Compliance companies should shift away from a project approach to a continuous process of integrating sustainable compliance into

their corporate governance structure.

SEC Interpretive Guidance on ICFR

The SEC’s interpretive guidance.

The overriding principles of guidance are: 1. Adequacy2. Effectiveness3. Entity-level controls 4. Ongoing monitoring 5. Fraud risk considerations

Enterprise risk Management Relationships of objectives and components of ERM

Components of ERM

Enterprise risk Management

Tax Accounting Tax shelters not only have detrimental effects on tax collections, but also the stock and the cost of debt prices can be affected.The Joint Committee on Taxation defines a tax shelter as a schema designed to avoid taxation without exposure to loss or economic risk.

Tax courts have established several judicial doctrines to curb corporate tax shelters

Conclusion •Management roles and responsibilities are to ensure operational efficiency; enhance the quality, reliability, integrity, and transparency of financial reports; and ensure compliance with applicable laws, regulations, rules, and standards.• Management is responsible for all managerial functions, including decision making, performance assessment, fair presentation of financial reports, and the achievement of the goal of increasing shareholder value while protecting the interests of all stakeholders.• The success and long-term survival of the company is in the hands of the CEO, and thus, the personal attributes, ethical values, and professional characteristics of the CEO should match and be in line with the company’s values, visions, and strategic plans.• Key challenges facing CEOs include (1) CEO fiduciary duties, (2) CEO succession planning, (3) CEO duality, (4) CEO financial knowledge and understanding, (5) CEO pay and skill, and (6) self-serving and self-dealing CEOs.• Executive compensation includes salary, annual incentive compensation (bonus), long-term incentive compensation, stock option awards, stock award units, severance, change-of-controlpayments, retirement arrangements, and stock ownership.

• Several provisions of SOX directly or indirectly affect executive compensation packages, including (1) prohibition of personal loans to directors and executives, (2) reporting insider trading, (3) insider trading during pension fund blackout periods, and (4) forfeiture of certain bonuses and profits.• Two provisions of SOX pertain to management certifications of financial reports. Section 302 of SOX requires the principle executive and financial officers of the company to certify each periodic report filed with the SEC. Under Section 906 of SOX, each periodic report containing financial statements filed by a reporting company must be accompanied by certification of the CEO and CFO of the company.• Earnings management is defined as a managerial discretionary practice of timing strategic and operating decisions or choosing accrual estimates to manage short-term earnings. Any illegitimate earnings management can cause financial restatements.• A high-quality financial report is defined in this book as a financial report that is relevant, useful, reliable, and transparent.• Financial information is considered transparent when it provides shareholders and other stakeholders a clear understanding of the company’s KPIs.

Conclusion

• Principles-based accounting standards are expected to be more understandable, allow the use of more judgment by auditors on the quality of financial information• Financial restatements continue to be the major factor in the erosion of investor confidence and public trust. • The development of IFRS is now considered one of the most commonly used accounting languages worldwide. Convergence of IFRS and U.S. GAAP should benefit the global capital market. • The SEC requires that public companies design and maintain adequate and effective disclosure controls and procedures. • Section 302 of SOX requires the management of public companies to assess and report on the effectiveness of disclosure controls and the procedures of both quarterly and annual reports.• Section 404 of SOX requires management to document and assess the design and operationof the company’s ICFR and report on its assessment of the effectiveness of ICFR.• Section 404 of SOX requires the independent auditor to attest to and report on management’s assessment of the effectiveness of the company’s ICFR.

Conclusion