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Corporate FinanCe

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WhartononFinance ■ Corporate Finance, Vol.1

From dealing with new accounting rules to selecting investment vehicles,

finance executives are simultaneously pressured to keep their firms’ books inline while also taking advantage of new and rapidly multiplying opportunities for

revenue growth. Meanwhile, these opportunities often expose companies to new

forms of risk— so much so that financial risk management has become a critical

concern for most organizations. In this collection of articles, Knowledge@Wharton

looks at financial risk in the context of private equity investing, venture capital, and

the use of derivatives, as well as the less obvious risks executives should take

into account when making decisions about business process outsourcing. Also,

Wharton faculty offer insight on how recent accounting regulations will impact

executive compensation.

Corporate Finance



Private Equity Is on a Roll, but Are Investors in for a Let-Down? 4

With private equity investors of all types flush with cash, private financing hit record levels in 2006 and islikely to remain strong in 2007, according to Wharton faculty and industry analysts. Nearly a third of the dollar

value of all U.S. acquisitions last year involved private equity firms, up from 3 percent 5 years ago. But just

how long can this boom continue, and what changes may be in store for private equity models?

Will It Pay Off, or Become a Writeoff? Managing Risk in Venture Capital Investing 8

Risk is part of the landscape when investing in startup firms, and venture capitalists need to approach this

peril across a range of dimensions, including geography, industry, and the timing of investments in the

product development cycle, according to speakers at a Wharton conference entitled Innovation and Organic

Growth: Balancing Risk and Reward , hosted by the Mack Center for Technological Innovation.

How New Accounting Rules Are Changing the Way CEOs Get Paid 12

When a well-known compensation consulting firm predicted in April 2006 that new accounting rules wouldn’t

have any impact on the use of options as compensation for corporate executives, Wharton Accounting

Professor Mary Ellen Carter was ready to disagree. “That’s just not true,” she says. “Options will be cut, and

directors will be switching to restricted stock for executive compensation.” Carter’s response is the result of

her research into the role of accounting in the design of CEO equity compensation, which is also the title of a

recent paper she coauthored.

Finding Value for BPO Through Revenue Distance 16

Evaluating and ranking each business process for its contribution to creating value for customers and the

company is a central part of a new model to help finance executives make outsourcing decisions, developedby Ravi Aron, senior fellow at Wharton’s Mack Center for Technological Innovation. Called the Revenue Distance

model—since it measures the distance between a process and revenue creation—the tool offers a simple way

for executives to put a comparative valuation on each business process that is a candidate for outsourcing.

The Role of Derivatives in Corporate Finances: Are Firms Betting the Ranch? 19

Many American corporations use derivatives to offset risks from fluctuating currency and interest rates. But

some have run into serious financial trouble using derivatives in a more dangerous fashion— to speculate. Are

shareholders in for ugly surprises if executives’ derivatives bets go sour? To get a better picture of derivatives’

role in corporate finances, Wharton Finance Professors Christopher C. Geczy and Catherine Schrand and

Bernadette A. Minton of Ohio State University reexamined confidential responses from an earlier study that

focused in part on derivatives.

Contents

©007UniversityofPennsylvania ■WhartonExecutiveEducation ■Knowledge@Wharton




with private equity investors of all types

flush with cash— from venture capitalists and

hedge funds to large leveraged buyout (LBO)

firms such as The Blackstone Group and The

Carlyle Group— private financing hit record

levels in 2006 and is likely to remain strong in

2007, according to Wharton faculty and industry

analysts. Nearly a third of the dollar value of

all U.S. acquisitions last year involved private

equity firms, up from just 3 percent 5 years

ago, according to U.K.-based Dealogic, which

tracks the investment industry.

General Electric reportedly has invited private

equity firms to bid for its plastic divisions in adeal that could be worth more than $10 billion.

The nation’s largest casino operator, Harrah’s

Entertainment, is weighing a $15.5 billion

bid from a team of private equity players. In

November, shareholders of hospital company

HCA approved a $33 billion private equity

buyout, topping the prior record of $31.3 billion

paid for RJR Nabisco in 1989. The RJR Nabisco

deal, chronicled in The Barbarians at the Gate ,

has come to symbolize the 1980s buyout era

that ended with the crash of highly visible junk

bond deals.

With $660 billion in corporate buyouts last

year and a war chest of $750 billion still to

deploy, private equity investors are on a roll, but

concerns about the sector’s ability to deliver

sizeable returns are also welling up. Angel

investor Rob Weber’s first reaction was surprise

when a hedge fund swooped in a few weeks

ago to snap up the entire $10 million second-

round financing of a life sciences startup he

owns. He flashed back to the high-tech boom

that went bust in 2000. “A warning flag went up

in my head,” he says. “I hope we’re not in for a

repeat of the bubble era.”

Wharton Finance Professor Pavel Savor echoes

the note of caution. “Everything is very peachy

now, and maybe the only way to go is down,

but I would say that nothing is imminent,” he

says. “Last year was the best on record by size,

and 2007 in all likelihood will be even better in

terms of activity. Whether it will be a good year

for investors is an open question.”

Savor says lenders remain eager to accommodate

buyout firms, and debt ratios are nowhere near

the alarming levels that led to the junk-bond

collapse following the buyout binge in the late

1980s. “A couple of high-profile bankruptcies

could change that,” he warns, “but for now, the

buyout shops have a little space to breathe.”

Much of the investment in private equity has

been concentrated at the industry’s largest and

best-known firms, Savor points out, noting that

investors are eager to place investments with

the top firms because they tend to get better

terms than with smaller companies. And, in

order to preserve their reputations for future

deals, the big players are also less likely tolet firms they control go bankrupt. “They have

career concerns and do not want to default,”

Savor says.

New Roles for Private Equity

According to Wharton Management Professor

Saikat Chaudhuri, the rush to fund private equity

is blurring some of the lines that were once

drawn between venture investment, hedge

funds, and leveraged buyout companies. Hedge

funds, which once focused mainly on publiccompanies and had a short-term horizon, are

now also delving into privately held firms and

even small venture-type investments that may

require patience. Private equity firms, often

working together in teams, are now going

after increasingly large deals that once were

considered so big only the public markets could

provide financing. “Private equity firms are no

Private Equity Is on a Roll, but Are Investors in

for a Let-Down?

The rush to fund private equity

is blurring some of the lines that

were once drawn between ventureinvestment, hedge funds, and

leveraged buyout companies.




longer spreading themselves thin in a lot of

investments,” says Chaudhuri. “Now they are

going after more mature investments even if

there is a smaller return, but that’s better than

just parking the money or not doing much with it.”

As buyout deals grow larger, firms may find

that simple financial engineering techniques will

not create enough new value to generate the

kind of above-average returns that many privateequity investors have come to expect, adds

Chaudhuri. Typically, buyout firms come into a

new company and can quickly create value with

a new financial structure, simple operational

fixes, or big cuts in the workforce. “As you start

to get into these large deals— in the double-digit

billions— that’s going to require management

expertise in the field and probably also holding

the company for a longer period of t ime.”

Wharton Finance Professor Andrew Metrick says

there should be little concern that shareholders

are being shortchanged in the large buyout

deals. In the wake of public scrutiny following

the scandal at Enron and the 2002 Sarbanes-

Oxley Act, operating a public company has

become more difficult and potentially less

efficient for many managers. “There are

executives who believe their companies are

worth more and would function better in the

hands of pr ivate owners,” says Metrick.

In the past, he adds, private ownership was

considered less efficient than a public structure

because it tended to concentrate equity in thehands of just a few owners. Now, however,

large buyout firms spread ownership widely

because most of their partners are often big

investors, such as pension funds.

He also points out that the major LBO firms

that have been generating a lot of publicity

are growing but are still dwarfed by the

public equity markets. He estimates that after

leveraging their capital, private equity firms

would be able to target $2 trillion in U.S.

investment. By comparison, the public equitymarkets are valued at $13 trillion. “Private

equity was historically a niche industry,” says

Metrick. “It got a lot of press in the 1980s

when it first emerged but throughout most

of the 1990s was small relative to the public

markets. Now it’s become noticeable again.”

Harry W. Clark, managing partner of Stanwich

Group LLC, a Greenwich, CT, consulting firm,

says it is unlikely that a large private equity

buyout firm will ever make a hostile bid for a

public company. “You may see more actively

hostile actions by hedge funds, but for the

serious, mature players in the large private

equity sector, the nature of their business lies

in a relationship with management.” Major

investment banks, however, may begin to carve

out new business as consultants to public

companies that want to develop strategies tocompete with the private equity funds, he adds.

Chaudhuri suggests that the rise of private

equity buyouts is putting pressure on public

company management but that it may also

be a transitional phase as the economy

rebounds from the weakness that began with

the technology investment crash of 2000.

Companies that fall under the control of private

equity firms, he argues, will ultimately wind

up in the arms of strategic buyers in their

own industries. Those transactions will bring

firms to the next level of business innovation

and productivity. “After the boom, there was a

slowdown, and a lot of firms were struggling.

As they are rebuilding themselves in a growing

economy, the strategic buyers are not yet in

a position to consolidate,” Chaudhuri says.

“The private equity firms are coming in and

streamlining some of the companies. Eventually,

in my view, they will be sold to strategic buyers

once again.”

Too Much Money, Too Few DealsIn the venture investment sphere, Raphael

Amit, Wharton professor of entrepreneurship

and management, says the picture is mixed. On

the positive side, activity is strong, and even

large investment firms are willing to take on

small, seed and first-round financing. “That’s

very good news for innovation in the United

States. These top-tier firms used to not want to

do small deals. Now they are willing to do them

just to get their foot in the door.”

On the downside, he says, returns are, onaverage, close to those of the S&P 500, with

only the best-known firms generating returns of

30 percent to 40 percent. “The top-tier firms are

completely oversubscribed. If you want to [get

into] the sector, you should only invest in them,

but they’re not taking in any new investors.”

Amit points to Sevin Rosen, a prominent venture

firm with offices in Silicon Valley and Dallas that




raised more than $200 million from investors

last year. This fall, Sevin Rosen sent the money

back, saying it could not invest the cash

productively because there were already “too

many deals funded in almost every conceivable

space.” Sevin Rosen also cited a weak exit

environment for private investors hoping to cash

out through an initial public offering (IPO).

Amit says liquidity events, such as an IPO or asale to strategic buyers in the same industry,

are now taking much longer than they once

did. In 1999, it took less than 2 years for

investors to cash out of an investment through

an IPO, but in 2006 it took more than 5 years,

he notes. The timeframe has also expanded

in the other chief form of private equity

exit— merger and acquisition deals. In 2001,

it took an average of about 18 months to do a

sale or merger, but by 2006 the timeframe had

stretched to more than 5 years.

Savor points out that private equity firms mayshift toward a completely new model in which

funds hold companies longer and repay their

investors through dividends. “In the past, IPOs

were the preferred exit, and I would say they

will remain so in the future,” he says. “But if

for some reason they do not, private equity

shops will find other ways to monetize their

investment— as long as there is something to

monetize.” While U.S. public offerings have

been limited, Amit points out that exchanges in

London, Hong Kong, and elsewhere have been

sponsoring a healthy number of new listings.According to Metrick, private equity firms may

also cash out of investments by selling to other

private equity firms.

Wharton Management Professor Mauro Guillén

says private equity will continue to play an

important role in Europe, where companies

are still undergoing restructuring related to

the creation of a single European market and

the subsequent expansion of that market into

new countries. “I don’t think there’s been

enough M&A and LBO activity. Private equity

is a part of this whole story in Europe. I don’t

think we’re anywhere near the end of this,”

says Guillén. “The adjustment by business in

terms of the restructuring and consolidation of

industries has been lagging behind the great

progress made in expanding the size of the

market and removing barriers. I think it’s going

to keep going for a long t ime.”

Guillén is less optimistic about continued private

equity strength in Latin America following

moves in several countries toward more

populist policies. He points to Venezuela, where

newly reelected President Hugo Chavez has

vowed to nationalize the nation’s power and

telecommunications sectors. In Asia, China

continues to be a draw for all forms of capital,

including private equity, says Guillén. India, too,

presents opportunities. While India has somemodern, highly-efficient industries, such as

software development and business services,

many sectors are in dire need of the kind of

restructuring that attracts private equity investors.

The boom in private equity finance has drawn

the attention of regulators. In Britain, the

Financial Securities Agency (FSA), which

oversees financial markets, issued a report

in November stating concerns that the U.K.

private equity market is overextended. The U.S.

Department of Justice this fall sent letters of

inquiry to several major private equity firms.

The focus of the probe appears to be on large

consortium, or so-called “club” deals— in which

private equity firms combine to take on large

transactions— and on whether the firms may

have collaborated in some way to reduce the

price of the bid.

Chaudhuri says increased regulation in the

United States is not likely unless a major deal

goes sour. “I do think some pressure will come,

so this free rein is no longer going to be there.

If one of the largest deals doesn’t do so well

under private equity, that’s when [we will see]

some regulatory pressure.”

Weber, the angel investor who is also

chief executive of Intellifit, a startup that

markets guaranteed-fit technology for online

apparel shopping, says he had been hearing

about hedge funds moving into traditional private

venture investing. “It seemed illogical to me,” he

says. “Then suddenly i t was in my own backyard.”

Weber says today’s buyout environment is less

perilous than in the era of Gordon Gekko, the

Private equity rms may shift toward a

completely new model in which funds

hold companies longer and repay their

investors through dividends.



©007UniversityofPennsylvania ■WhartonExecutiveEducation ■Knowledge@Wharton 7

buyout artist portrayed by actor Michael Douglas

in the film Wall Street , who famously proclaimed

that “Greed is Good.” In those days, Weber

says, the use of junk-rated debt fueled the

excess. Still, he finds it worrisome when hedge

funds get involved with startups because they

may not have enough experience in the volatile

venture world to help make their investments

succeed. “Everybody’s happy when things are

up, but when they are bad, I’m not sure howprepared a hedge fund will be to navigate the

rough waters of an entrepreneurial startup.”

Weber is also concerned about the risk that

private equity firms themselves are engaged in

a sort of ponzi scheme in which buyout firms

sell companies to one another at increasingly

high prices that ultimately will crash. “Having

lived through the bubble era, when I see

irrational exuberance, or signs of it, I get a bit

concerned because the venture industry has

worked hard to return to sanity and an era of

logic,” says Weber. “I was start ing to feel goodagain about the work we do. I still do, but now I

have this flag that has gone up which is causing

me to be a little bit worried.” ■




risk is part oF the landscape when

investing in startup firms, and venture

capitalists need to approach this peril across

a range of dimensions, including geography,

industry, and the timing of investments in

the product development cycle, according to

speakers at a Wharton conference entitled

Innovation and Organic Growth: Balancing Risk

and Reward , hosted by the Mack Center for

Technological Innovation. “We have generated a

lot of wealth for people and also created our fair

share of losses,” Spencer Hoffman, a pr incipal

at Safeguard Scientifics, noted during a panel

discussion entitled, Financial Perspectives on

Managing Risks.

Hoffman and his fellow panelists from the venture

capital industry discussed how firms determine

which new technologies— whether from the

energy, high-tech, or health care sectors— are

good investments and what strategies they

employ to manage and mitigate risk.

Prior to the discussion, Wharton Finance

Professor Andrew Metrick explained how

financial economists view risk by citing

two hypothetical companies— Box Co., anestablished manufacturer of corrugated boxes,

and Drug Co., a biopharmaceuticals company.

Box Co.’s returns rise and fall with the overall

economy, while Drug Co. is working on a cure

for a host of diseases but has little probability

of success. Assuming both companies have

the same expected cash flow, which company

would be expected to generate higher returns

for investors? Metrick asked.

He explained that while the drug company

has a high level of individual, or idiosyncratic,

risk, the box company should offer a premium

to investors willing to back it in bad times as

well as good. “The box company does well

when people are already doing well. It has poor

returns when the economy is poor and people

are hungry,” Metrick noted. “If someone says,

‘I will hold Box Co., which will not pay much

exactly when I am most hungry,’ then they need

to be compensated.”

Investors in the drug company could mitigate

their risk by buying up shares of many drug

companies, hoping at least one will come up with

a hit product to justify the overall investment.

More widespread risk may be difficult to insure

against— such as a sudden hike in the cost of

natural resources— but companies need to take

steps against this type of threat if it begins

to erode operations. He used the example of

a well-run airline company facing a sudden oil

price hike beyond its control. Shareholders in

the firm could hedge against an oil shock by

creating a portfolio that benefits from higher oil

prices. But as owners of the airline, they also

need to be concerned that the oil shock will

impact sales and will result “in distress costs

at the airline.” One strategy is using a collar

on the price paid to limit exposure to severe,

operational risk without attempting to insure

against all risk at any price, Metrick said.

He also explained why small venture capital

firms take on so much more risk in backing long-

shots than do large corporations that have more

resources or appear to have the ability to absorb

Will It Pay Off, or Become a Writeoff?

Managing Risk in Venture Capital Investing




a swing and a miss. Executives and employees

at a large company all share in the downside of

problems when problems arise at the targeted

firm, he said, but the benefits of hitting a home

run with a new technology investment are

diluted. He noted that even the largest venture

capital firms have very few partners, allowing

each to win big if a high-risk investment pays

off. “These are small organizations. When they

get too big, the incentives for any one personaren’t so clear,” said Metrick. “If someone is

better than their partner, then they leave and

start their own firm.”

Panelist Michael DeRosa, managing director

of the DFJ Element Fund, an affiliated fund of

Draper Fisher Jurvetson in Menlo Park, CA,

agreed. “It’s not just that venture capital firms

have more incentives to invest, but that large

corporations have less,” he said, adding that

he was surprised recently when a large public

company came to his firm offering an ownership

stake in an attractive new technology. The

company wanted to reduce its own stake to

less than 20 percent to get the development

costs off its books where they were cutting into

quarterly earnings. “This [technology] looks like

a huge home run, but right now it’s a hit to their

earnings, and they don’t like that.”

The DFJ Element Fund is focused on

technology, particularly in energy and other

heavy industries, and on companies that

are developing solutions to old economy

problems, he said. “The theme is to take the

venture capital method that works in high-techinformation technology and biotech and apply it

to growth opportunities in the real core sectors

of our economy,” said DeRosa, who added that

rising petroleum prices are generating interest

in the DFJ Element Fund’s strategy.

According to DeRosa, his firm approaches

risk management on two levels. The first is

at the portfolio strategy level, which calls

for diversification across industries. He

acknowledged that is not as easy for a fund

with a specific strategy like DFJ Element, as it

would be for a general technology investment

fund that, for example, can invest in both

biotech and software.

To combat that problem, DeRosa said the firm

shifts from a risk-management approach tobuilding expertise and networks in its own

specialty. Investors can then select the best

venture capital firm in each area of technology

to build their own diversified portfolios.

DeRosa added that the firm has tried to

construct mathematical models to guard against

putting too much money in one investment in

case something goes wrong, such as a change

in government regulation. He said the firm at

one point was overly dependent on the pace of

deregulation in the utility sector, which occurred

slower than expected. Another influencing

factor is the tolerance for risk in the public

markets, which was high in the late 1990s and

in 2000, but dried up in 2001 through 2003 with

the collapse of technology stocks.

The firm’s second level of risk management

entails making investments within the venture

company. To diminish the risk of a technology

firm failing, he said, DFJ Element installs good

management and financial systems. “Then if

the technology works, you’re golden.”

He added that fund managers look for a product

or technology that works but is not living up to

its promise because it is locked in a company

with operational problems.

The notion of risk in emerging technology is

fundamentally different than with an established

company, DeRosa said. “I think of risk as

something you have and lose. We work with

companies that don’t have anything yet, and we

work to get it there.”

Investing in Health Care

Panelist Asish Xavier, a principal in Johnson &

Johnson Development Corp., said the health

care company’s 33-year-old venture group

“[keeps] an eye out there for new technology.”

Excluding early-stage seed investments, the

fund’s managers view risk in two buckets:

one is technology risk, and the other involves

More widespread risk may be

difcult to insure against—such as

a sudden hike in the cost of naturalresources—but companies need to

take steps against this type of threat

if it begins to erode operations.



10 WhartononFinance ■ Corporate Finance, Vol.1

business issues, such as potential legal,

financial, and management problems.

Xavier’s firm also looks at long-term

investments across several dimensions. First,

the company is a global investor with holdings

in Europe, Israel, and Canada. During the recent

bubble, European nations offered subsidies in

biotech firms, but many of them are struggling

since the market has cooled. Those firms arenow rationalizing and merging, creating new

opportunity for JJDC. “We’re not a fund tied by

geographic ability to invest, so we can invest

more broadly and manage our portfolio” with

more flexibility.

The fund also invests across three major

health care sectors— biopharmaceuticals,

biotechnology, and medical diagnostics— and

builds its portfolio across different phases of

product development, from the early preclinical

stage through drug discovery and finally into

clinical testing. Since the fund is not primarily

driven by its internal rate of return, JJDC can

invest in technologies that are out of favor, said

Xavier. He noted that biotech products typically

take 10 years to develop, while most venture

funds have a shorter time horizon than that.

After the bust in biotech (following a boom

based on the promise of genomics), health care

has not been generating much interest among

investors. However, he pointed out, health care

technology companies are beginning to show

some strength. A big trend driving the industryis an effort to reduce the time it takes to develop

a new drug— from 7 to 10 years down to 3 to

5 years. Reducing the time to market allows

companies to take more advantage of the time a

new product remains protected by patents.

Another major trend bolstering pharmaceuticals

and biotech venture investing is the repositioning

of compounds. Companies eager to fill weak

drug pipelines are going back into product

portfolios to test old drugs for new uses.

Since the products have already been provensafe, the development time and costs are

reduced. Companies are also looking abroad

for successful compounds that could be

introduced in the U.S. market. And the industry

is benefiting from the increase in outsourcing of

research to countries where costs are lower. He

said firms are looking to move chemistry labs to

Eastern Europe and clinical trials to India.

Health care venture investors are also active

in looking for spin-outs of products, or parts

of companies that could fare better on their

own. In addition, medical devices are gaining

new attention from health care investors,

following the biotech bust. “The larger funds

are diversifying into medical devices to hedge

their port folio,” he said, adding that health care

investors are pulling back from early-stage

investments to focus on compounds that havebeen proven safe in the short term and are in

Phase 2 studies to determine whether they

actually work against targeted diseases. “We

know the returns will be capped, that there is

a higher chance of giving up a home-run, but

there is greater certainty.”

Liquidity and Diversification

Spencer Hoffman, a principal at Safeguard

Scientifics, presented another take on venture

investing and risk from the viewpoint of hiscompany, a publicly traded investment firm

specializing in information technology and

health care.

Safeguard has had its share of success,

Hoffman said, such as its investment in

Cambridge Technology Partners, which was

acquired by another Safeguard startup, Novell

Inc., in 2001. Yet it has also suffered with other

firms, notably the well-publicized collapse

of Internet Capital Group in 2000. “We have

generated a lot of wealth for people and also

created our fair share of losses.” As a public

company, Safeguard provides investors with

liquidity, he said. “If you like what we have to

say, you can go out and buy Safeguard. If you

don’t, you can short Safeguard or change either

way in an hour.”

Most of Safeguard’s shareholders are

individuals, not the large insurers or pension

funds, or qualified investors that can participate

in elite venture funds. “Our model is providing

a liquid and transparent way for people to

participate in alternative asset classes and getdiversification that way,” Hoffman said.

Safeguard’s model is to mitigate risk and

create above-average returns by selecting

the right companies in areas where the

firm has expertise. Then, using Safeguard

partners or networks, the company uses its

own entrepreneurial experience to help build




or improve the businesses. “What we try to

do is bring a little bit of the buyout model

to the growth equity space and look for

opportunities venture capitalists won’t touch

because management isn’t perfect or some

element of the execution isn’t there.” Hoffman

stressed that a key to reducing risk is to pay

the right price and structure the terms of the

deal correctly in the first place. “The real way

venture capitalists mitigate risk is with theterms,” he said.

Furthermore, in designing compensation for the

founders and managers of venture companies,

many funds have a bias against allowing

management to cash out much of its equity in

order to keep as much capital as possible in

the business. Hoffman joked that this results in

founders with bruises on their heads inflicted

by spouses who see a lot of wealth on paper,

but have been waiting years to buy a summer

house or are concerned about how the family

will finance its children’s education.

Safeguard is more inclined than other firms to let

founders have some money early on, according to

Hoffman. As long as a big chunk of their wealth

is still in the company, he said, founders who

have been able to tap into some of their equity

are likely to be better managers. He argued theyare less concerned about the downside if they

have been able to profit to some extent from

their entrepreneurial risk. “Actually I’m surprised

more firms don’t do this,” he said. “If the owners

of the firm are not concerned about paying for

their children’s education, either they are total

risk seekers or independently wealthy with no

commitment. Those are the people you want to

run away from.” ■




when a well-known compensation consulting

firm predicted in April 2006 that new accounting

rules wouldn’t have any impact on the useof options as compensation for corporate

executives, Wharton Accounting Professor Mary

Ellen Carter was ready to disagree. “That’s just

not true,” she says. “Options will be cut, and

directors will be switching to restricted stock

for executive compensation.”

Carter’s response is the result of her research

into the role of accounting in the design of

CEO equity compensation, specifically as it

relates to the use of options and restricted

stock. Her study coincides with a recent ruling,implemented by the Financial Accounting

Standards Board (FASB), requiring all firms to

expense the value of employee stock options.

Specifically, Carter looks at the accounting

practices of 1,500 firms from 1995 to 2001,

before many large companies began expensing

stock options but during the years when

the FASB began pushing the reform. Carter

corroborates the findings of her study by

examining changes in CEO compensation within

firms that voluntarily began to expense options

in 2002 and 2003.

In a paper on this topic entitled “The Role

of Accounting in the Design of CEO EquityCompensation,” Carter concludes that CEO

compensation will change now that companies

are required to subtract the expense of stock

options from their earnings, just as they are

required to account for salaries and other costs.

And Carter predicts that as a result, firms will

switch from options to restricted stock as a

preferred compensation option.

“By eliminating the financial reporting benefits

of stock options, firms expensing stock

options no longer have an ability to avoid

recording expenses with any form of equity

compensation,” writes Carter, who authored

the study with Luann J. Lynch, a professor

at the Darden Graduate School of Business

Administration, and Wharton Accounting

Professor Irem Tuna.

“We found that companies prior to the rule

changes granted more options because of

favorable financial reporting. Results suggest

that favorable accounting treatment for stock

options led to a higher use of options and loweruse of restricted stock than would have been

the case absent accounting considerations. Our

findings confirm the role of accounting in equity

compensation design.”

Leveling the Playing Field

The timing of Carter’s report could hardly

be better.

This past year, a revised FASB rule took effect

that requires companies to expense the value

of stock options given to employees. Most

public companies are required to expense

options for fiscal years beginning after June

15, 2005. Since most companies operate on a

calendar basis, this means expensing options

by March 31, 2006. Known as SFAS 123(R), the

new accounting standard was developed by the

FASB to create a more level playing field when

it came to management incentive compensation

and its impact on a company’s bottom line.

Before SFAS 123(R), companies that gave out

stock options did not have to report the “fair

value of the option”— that is, they did not have

to claim the options as an expense, which in

turn would result in a reduction in net income at

the end of the fiscal year. However, companies

that relied on cash bonuses or restricted stock

for equity compensation have always had to

report or “expense” the value amount, an

accounting requirement that reduced corporate

net income at year’s end.

How New Accounting Rules Are Changing the

Way CEOs Get Paid

The new accounting standard was

developed by the FASB to create

a more level playing field when it

came to management incentive

compensation and its impact on a

company’s bottom line.




The FASB first proposed changing the

accounting standard in 1991. At the time, the

move was strenuously opposed, particularly by

many high-tech firms and startup businesses

that relied heavily on stock options as an

incentive to recruit and motivate employees

to work for companies that reported little or

no income. As nearly everyone knows, stock

options are perks given to employees that

allow them to buy company stock in the futureat a set price. If the stock rises before the

options are exercised, the employee can buy

the stock at the lower predetermined price

and then sell it at the higher price and quickly

realize the difference.

During the dot-com boom, the use of stock

options skyrocketed. According to the National

Center for Employee Ownership, up to 10

million employees held stock options by

2002. “Stock options were always seen as

an incentive, a way of tying employee or

executive action and company performance

to compensation,” says Carter. “In other

words, ‘You will get something if you get the

stock price to go up.’ It was a way of aligning

employees’ and executives’ interests with those

of the shareholders.”

But from the beginning, companies balked

at putting a numerical value on options and

expensing them, arguing that doing so would

result in a negative impact on their stock price.

After intense lobbying, the FASB backed off

the proposal in the early 1990s, but issueda compromise, known then as SFAS 123:

Companies had to disclose the use of stock

options and their fair value in the footnotes of

their financial reports or proxy statements.

Nearly 10 years later— in the wake of the

volatile post-Enron era, when improper and

unethical accounting practices were widely

exposed in one corporate scandal after

another— the FASB returned to the concept of

expensing stock options. At the time, corporate

institutions like Global Crossing and WorldCom,in addition to Enron, had became synonymous

with corporate greed, and anyone who followed

their downfalls quickly understood how

company executives who held substantial stock

options were motivated to artificially inflate

stock prices for their own financial gain.

In an effort to distance themselves from

companies that routinely “cooked the books,”

many corporations wanted to showcase their

ethical financial practices. So they began to

voluntarily expense options in their proxy

statements, a step above and beyond the

footnote citation already required by the FASB.

In 2002, General Electric, Bank One Corp.,

Coca-Cola, The Washington Post Co., Procter

& Gamble, and General Motors announced

that they would expense options, along with

Amazon.com and Computer Associates. Somecompanies— like Papa John’s International, USA

Interactive, and Microsoft— announced that they

were doing away with options altogether.

The push for corporate accountability and

more transparent financial accounting

practices received an undisputed boost

with the Sarbanes-Oxley Act of 2002, which

required that executives and auditors evaluate

internal financial controls and be accountable

for financial statements. In turn, the FASB

responded in early 2004 by presenting therevised draft of its accounting standard related

to options expensing, or SFAS 123(R). This

time, there was little protest, primarily because

companies had already responded to the

suggested changes and were resigned to the

practice of expensing options.

As BusinessWeek reported on April 1, 2004:

“Like an approaching hurricane that generates

more advance warnings than damaging

winds, FASB’s proposed rule probably won’t

cause a lot of additional change. Some 500

publicly traded companies have already started

expensing options, or said they will. Many

have begun shifting toward other nonoption-

based pay schemes that are likely to deliver

more motivational bang for their compensation

bucks. And investors, who can already look up

option costs in the footnotes of companies’

quarterly financial reports, seem to have grown

accustomed to factoring the values of options

into what stocks are worth.”

What, then, was the impact of accounting

practices in the compensation choices

for CEOs? Noting that “prior literature is

inconclusive,” Carter set out to determine

whether favorable accounting for stock options

had motivated the use of options, deterred

the use of restricted stock, and led to higher

overall executive compensation. Carter and

her fellow researchers focused on the use

of options in CEO compensation before the




new accounting standards went into effect—

through either voluntary or required measures.

They studied 6,242 executive compensation

packages from 1995 to 2001, using information

from ExecuComp, a database of executive

compensation information that covers the

S&P 1500.

Carter’s study found that the “method of

accounting for options has affected decisions

regarding their use.” Among the findings:

Between 1995 and 2001, approximately80 percent of the ExecuComp firms were

granting options to CEOs, while only

approximately 20 percent of these firms were

granting restricted stock to their CEOs.

The use of stock options increased steadily

throughout the sample period. Specifically,

the percent of sample firms granting options

to CEOs increased from 76.5 percent in 1995

to 82.3 percent in 2001.

Firms in the sample used very little restricted

stock compared with options. However, the

use of restricted stock to compensate CEOs

increased steadily throughout the study

period, from 18 percent of firms in 1995 to

21.6 percent in 2001.

Notes Carter, “We find that firms that are

more concerned about the earnings they

report used more stock options in their equity

compensation, due to the favorable accounting

treatment for options, and that once firms

start expensing stock options, they shift into

restricted stock. Our analysis provides insightinto what changes are likely to occur in CEO

equity compensation now that the FASB has

made stock option expensing mandatory.

While we may not see an overall decrease in

CEO compensation, we anticipate a decline in

stock option use and an increase in the use of

restricted stock.”

■

■

■

Testing the Hypotheses

To corroborate these findings in her report,

Carter also studied 206 firms from the same

ExecuComp database that began to expense

stock options in 2002 or 2003. Carter’s goal

was to determine “whether firms that expense

stock options alter CEO equity compensation

packages in response to the decision to

expense options.” Based on these firms’experiences, “we examine changes in the

structure of CEO pay packages concurrent with

and after the decision to expense options,”

Carter says. “Using this sample, we are able to

test our hypotheses without having to rely on

a proxy for firms’ financial reporting concerns.

Our findings confirm the role of accounting in

equity compensation design. We find that firms

expensing options decrease compensation

from options and increase compensation

from restricted stock, even after controlling

for standard economic determinants ofcompensation and general economic trends.”

For instance, Carter found that before

expensing options, 88.7 percent of the firms

in this subgroup were granting options as part

of a CEO’s compensation; during the year the

firm first expensed options, the number of

firms granting options dropped 18.6 percent,

down to 68.9 percent; the year after expensing

for the first time, the number of firms granting

options dropped further to 64.3 percent for

a total decrease of 23.7 percent. In contrast,

the number of firms granting restricted stock

to CEOs grew from 42.8 percent in the year

before expensing options to 55 percent the year

after expensing, an increase of 12.2 percent.

During an interview, Carter pointed to proxy

statements from the following two corporations

to illustrate how companies shifted from options

to restricted stock for CEO compensation:

From Liberty Property Trust, proxy statement

filed on March 26, 2004: In making long-term

incentive compensation awards with respect to2003, the Compensation Committee, as it did

with respect to 2002, placed greater emphasis

on restricted shares and less emphasis on

options as compared to past awards of long-term

incentive compensation…. In part, this change is

a reflection of the Trust’s determination to begin

in 2003 to record options as an expense at the

time of issuance. Additionally, greater reliance

The researchers set out to determinewhether favorable accounting for

stock options had motivated the

use of options, deterred the use of

restricted stock, and led to higher

overall executive compensation.




on restricted shares reduces the potential

dilutive impact from option grants. This change

is intended to provide appropriate long-term

incentive to Named Executive Officers that is

competitive and consistent with the interests

of shareholders.

From FBL Financial Group, proxy statement filed

on March 31, 2004: For 2004 we have included

grants of performance-based restricted stock tothe executive group. This change is partially in

response to our expensing of stock option costs,

and partially to create more performance-based

incentives for this key group. We traditionally

grant stock options to executives and other key

employees each January 15. For the 2004 grant,

we have determined a target level of incentive

awards to this group, then divided it by value,

50 percent in stock options and 50 percent in

performance-based restricted stock.

And what, if anything, happened to the amount

of executive pay packages? Carter found “no

evidence of a decrease in total compensation”

to CEOs once companies expensed options.

The fact that executive pay did not decrease

led Carter to one of two conclusions: Either

the favorable accounting treatment for stock

options did not lead to higher levels of

executive compensation “or firms find it difficult

to downsize the large executive pay packages

that resulted from the favorable accounting

treatment for stock options,” Carter writes.

In summary, Carter concluded, the fact that“firms are granting fewer options and more

restricted stock suggests that these firms are

shifting towards restricted stock [in order to]

provide longer-term performance incentives

and that there will likely be changes in CEO

compensation now that SFAS 123(R) is

effective. Though firms may have appeared to

favor options, under a regime of mandatory

expensing, the role of options in executive

compensation may be restricted.”

Like an asterisk at the bottom of a key

paragraph, Carter and many others who studied

the ramifications of options expensing admitthat the drop in granting stock options is

something of an “unintended consequence”

of the new FASB requirement. Why? Because

the financial markets have proven to be

relatively efficient; the accounting change to

options expensing has actually not resulted in

a significant drop in corporate stock prices, a

byproduct once feared by companies opposed to

the change. In 2004, a study by compensation

consultant Towers Perrin of 335 companies that

voluntarily began to expense options found

no impact on their stock prices; another study

by Bear, Stearns & Co in 2004 predicted that

the options expensing change would reduce

reported earnings of S&P 500 companies by less

than 3 percent, according to BusinessWeek.

“There really shouldn’t be a problem,”

Carter says. “The value of the options was

in the footnotes. Anyone who is a hard-core

market efficiency person would say that any

information that is public is already included

in the stock valuation. So expensing options

shouldn’t be making any difference at all. But

it is. Companies are cutting back on options

because they believe that there is an impact to

expensing, but there really shouldn’t be.” ■




in the last decade, companies have

discovered that outsourcing some tasks

to cheaper locations is one way to deliverefficiencies and cut costs. But the simple

act of outsourcing to a lower cost base has

evolved into a complex process that can

inflict considerable damage if not dealt with

in a sophisticated and scientific manner. The

damage can range f rom not achieving the

expected cost savings to losing control to a

third party, particularly when a company’s more

essential processes are outsourced.

Questions concerning which business

processes should be outsourced and whetherthe outsourcing should be done onshore or

offshore require careful financial and strategic

consideration, says Ravi Aron, senior fellow

at Wharton’s Mack Center for Technological

Innovation. According to Aron, most

companies— about 60 percent of those who

outsource— focus only on cost savings, and

many fail to achieve those savings in addition to

not taking into account other opportunities that

outsourcing offers.

Linking Outsourcing to RevenueAs with everything that is complex, the best way

to ensure successful outsourcing is to ask the

right questions, Aron says. Before outsourcing

a business process, an executive should ask,

“How much does this process— compared to

other processes— contribute to our product’s

being better than the competition’s product?”

Evaluating and ranking each business process

for its contribution to creating value for

customers and to capturing that value for the

company is a central part of a model developed

by Aron to help finance executives make

outsourcing decisions. Called the Revenue

Distance model— since it measures the distance

between a process and revenue creation— the

tool offers a simple way for executives to put a

comparative valuation on each business process

that is a candidate for outsourcing.

In other words, Revenue Distance captures

the importance of a business process to the

company. Those that are ranked high are

critical for revenue generation and thus are

best held close to home; and those that have

low rankings could be, and perhaps should be,

outsourced, explains Aron.

A finance executive following the Revenue

Distance method should first rank every

process that is a candidate for outsourcing on

a 1 to 10 scale as though only one question

existed— How much does this process

contribute to creating value for my customer?

(One is most important; 10 is least.) Next, rank

the process for its contribution to capturing

that value for the company. Add up the two

ranks, and the resulting number is the Revenue

Distance of that process.

Finding Value for BPO Through Revenue Distance

Revenue Distance captures the

importance of a business process to

the company.




“The smaller the number, the lower is the

distance of the process from the point where

money is made— that is, the smaller the number,

the more critical the process, and it should not be

outsourced,” Aron says. “We say that processes

with moderate to large revenue distance are very

beneficial to outsourcing,” he adds.

The Revenue Distance model also recognizes

that the relative importance of value creationand value capture will be different for different

industries. For instance, a company in a nascent

industry would rank processes that help in value

creation very high. For mature industries such

as retail, banking, and hospitality, however,

value capture will be more important than value

creation. Apple Computer’s iPod, for example,

depends on the success of value creation, says

Aron. The company is good at product design

and, as such, will not consider outsourcing any of

its design processes. However, it can outsource

its value capture processes, such as retail and

distribution management. On the other hand, for

a company like Dell, whose competitive edge is

the way it manages its supply chain, outsourcing

distribution is not a good idea, he points out.

To accommodate business processes that rank

disproportionately high in value creation and not

in value capture, or vice versa, Aron says the

values for the disproportionate side should be

weighted to prevent a skew in results.

Keeping It In-House at a High Cost

Not only will this exercise allow finance

executives to determine what should be

outsourced, but it will also reveal those

processes that a company keeps in-house at

a very high cost. Some of these processes

enable the creation of value but are not crucial

to beating the competition, Aron notes. For

instance, in a financial services company

that originates home loans, such processes

as documentation and loan servicing are

necessary parts of the business but are not the

differentiators that help it achieve a competitive

edge. Therefore, such processes could be

outsourced, explains Aron.

Very often, the Revenue Distance exercise

reveals that more than 50 percent of business

processes in a corporation are responsible for

creating less than 25 percent of value and that a

handful of processes create a high percentage of

value, he says. Thus, by keeping the majority of

the low-value processes in-house, the company

could be leaving a lot of money on the table as

well as wasting managerial time and talent.

Aron gives the example of a large financial

services company that had been outsourcing

without going through the Revenue Distance

exercise. It found that some processes were

working out well, while others were prone

to repeated and costly breakdown. However,after applying the Revenue Distance model,

the company discovered that 3 out of the 10

processes they were outsourcing abroad were

not good candidates for outsourcing. Also,

the company also found a number of other

processes that should have been outsourced and

have since reworked their outsourcing strategy.

The Need for a Disciplined Approach

Using sophisticated tools such as Revenue

Distance has become critical as companies

now outsource not only information technology-

related processes but also business processes.

In fact, the most important trend in business

process outsourcing in the last 5 years is that

corporations have realized it is not a practical

operations decision, but a highly strategic

decision, he notes. “Depending on the scope

and nature of the engagement, there are

several different people involved in the decision

making. Very often it is at the highest level—

the chief financial officer or even the chief

executive off icer.”

The trend has emerged for a number of reasons,

including the recognition that outsourcing can

now have a direct impact on business line

objective. The strategic intent behind outsourcing

has changed too. It used to be cost savings, but

there are other virtues that companies try to

harvest from outsourcing, including increased

operational flexibility, says Aron. Also, there

is the cost-quality frontier, which favors one

location more than the other: If a retail bank, for

instance, is looking to lower transaction errors,

it will be more cost effective to set up a shop in

By keeping the majority of low-value

processes in-house, a company could

be leaving a lot of money on the table

as well as wasting managerial time

and talent.




India, China, or the Philippines where it could be

staffed by workers with master’s degrees and

financial or accounting backgrounds more easily

than in the U.S.

Despite the increasing critical nature of

outsourcing, only in the last 2 years have some

discipline and formal rigor been brought into the

process, Aron notes. The most common metric

used is called a “zero one” approach, whicheliminates a process from outsourcing that

could potentially cause the company to lose

significant revenues if something were to go

wrong. This model, however, results in several

necessary but noncritical processes being kept

in-house, leading to a big waste of managerial

time and talent. The Revenue Distance model

provides a concrete methodology for not only

identifying what business processes can be

outsourced but also what the cost is of keeping

them in-house, he notes. ■




many american corporations use

derivatives conservatively, to offset risks from

fluctuating currency and interest rates. But overthe years, companies such as Procter & Gamble

and Gibson Greetings have run into serious

financial trouble using derivatives in a more

dangerous fashion— to speculate.

Is high-risk behavior common? Are shareholders

in for ugly surprises if executives’ derivatives

bets go sour?

That has long been nearly impossible to

determine, says Wharton Finance Professor

Christopher C. Geczy. “It’s not well disclosed

in the financial [statements]. It could be

widespread, but it’s hard to say.”

To get a better picture of derivatives’ role in

corporate finances, Geczy, Wharton Accounting

Professor Catherine Schrand, and their co-author,

Bernadette A. Minton of Ohio State University,

reexamined confidential responses collected

in an earlier Wharton study that focused on

341 corporate respondents, 186 of which used

derivatives. The companies studied were not

concentrated in any one industry, but were part

of a broad sample of U.S. public, nonfinancialfirms. The researchers report their findings

in a paper entitled Taking a View: Corporate

Speculation, Governance, and Compensation.

“We found that there are corporations out

there, some of them very large, which have

speculated, or are speculating,” Geczy says.

Companies reporting that they frequently

“actively take positions” in currency or interest-

rate derivatives on the basis of likely market

movements were defined as speculators. The

researchers then looked at the nature of those

companies. They concluded that companies

typically speculate in hopes of adding to

profits but not to “bet the ranch” to get out of

financial difficulties or to hit it big. Executives

who conduct the speculation typically are not

renegades but instead are encouraged to do

so by their superiors and board. Furthermore,

firms that engage in speculation generally have

oversight and monitoring procedures to prevent

abuse. Finally, executives’ compensation was

often tied in some way to their success in

derivatives speculation.

“The main findings are that firms take positions

based on a view [of market conditions] when

they believe they have an information advantage

to predict rates, which is consistent with a

profit-making motive for speculation,” the

researchers write.

Derivatives are contracts whose values are

tied to price changes of underlying securities.

A typical currency derivative gives its owner

the right or obligation to buy or sell a block

of dollars, yen, or other currency over a given

period at a set exchange rate. Interest-rate

derivatives are like insurance policies that pay

off if rates move up or down a specified amount

during the time covered.

In one important use, derivatives can neutralize

risks. An American company that must

exchange dollars for yen to buy goods from

Japan could use a currency derivative to make

up the difference if the dollar falls and Japanese

goods become more expensive. Essentially,

the contract would allow the company to lock

in today’s exchange rate for a given period. The

American company would lose money on the

derivative contract if the dollar got stronger

instead of weaker, but that would be offset bythe lower cost of Japanese goods as dollars

were exchanged for yen.

A company could, however, use the same

currency contract to speculate, by simply

buying a contract in hopes it becomes more

valuable as exchange rates change. Since

the change in the contract’s value would

not be counterbalanced by a gain or loss

The Role of Derivatives in Corporate Finances:

Are Firms Betting the Ranch?

“We found that there are corporations

out there, some of them very large,

which have speculated, or arespeculating,” Geczy says.




in the purchase of Japanese goods, the

company would suffer a net loss if the dollar

strengthened and the contract loses value. This

is speculation.

In the 1990s, Procter & Gamble lost $157

million in a currency bet involving dollars and

German marks; Gibson Greetings lost $20

million; and Long-Term Capital Management,

a hedge fund, lost $4 billion with currency andinterest-rate derivatives.

“Shooting for the Moon”

Over the years, various theories have attempted

to explain why firms would speculate with

derivatives. One theory suggests it is practiced

at troubled firms “betting the ranch” to recover.

But Geczy and his colleagues concluded this is

unlikely, as the speculating firms tended to have

access to low-cost outside financing, which

made betting the ranch unnecessary.

In most cases, firms that speculate are

using types of derivatives they have gained

experience with through safer hedging

strategies. Those that speculate with currency

derivatives, for instance, typically operate in

international markets. As the authors write,

companies that speculate with foreign currency

derivatives “have a greater percentage of

operating revenues and costs denominated in

foreign currency relative to firms that never or

sometimes actively take positions.”

Executives in charge of derivatives speculation

tend to feel they have some unique insight into

currency and interest-rate markets, even though

their firm’s main business may be entirely

different, Geczy says. “They really believe they

can make money. They feel like they can identify

opportunities and/or trade with the advantage

of low costs of leverage.”

Another theory is that executives use

derivatives to “shoot for the moon”— trying

to push up the company’s earnings to boost

the stock price and thus the value of their

own holdings. But according to Geczy, the

goal appears to be more modest— just to

make some extra profit when they think the

opportunity arises. “On average, they do not

appear to be trying to make the firm really risky

to make big payoffs.”

At the same time, says Geczy, “just because

speculating firm managers do not appearto be shooting for the moon, so to speak,

doesn’t mean that there aren’t dangers or that

speculating firms cannot suffer large losses.

What makes our research interesting is that

these managers can, in fact, suffer large losses

even if speculation is rational and profit oriented.”

Generally, firms that speculate have structures

that give executives significant authority and

freedom. They may be well-insulated from

shareholder pressure by poison-pill anti-takeover

defenses, for example. As Geczy notes, “The

companies that speculate seem to be ones

where shareholders don’t have as much power.

It’s basically stronger managers…stronger,

confident management that thinks it can make

money. However, this in no way means they

are successful.”

As to whether there is more speculation going

on now than in years past, “this is quite hard to

say,” notes Geczy. “We actually did a followup

survey of respondents from the first survey and

found that some firms moved from speculating

to not speculating at all and, in fact, remarkedthat they didn’t feel speculation added much

value net of its risk. Others went from not

speculating to speculating with the expectation

of making a profit. So we see transitions in

both directions.”

The original survey did not ask companies to

report how much they earned or lost through

derivatives speculation. Geczy and his colleges

conducted followup interviews with some

of the companies’ executives but could not

determine how successful the speculation was.“It’s been fairly hard to track down whether

they actually do make money,” he says.

But Geczy questions whether these executives,

who typically speculate as a sideline to their

main duties, can effectively compete with

professionals who do it full-time. “It’s hard to

believe, frankly, that corporate treasurers know

more than the financial markets about what

In the 1990s, Procter & Gamblelost $157 million in a currency bet

involving dollars and German marks,and Long-Term Capital Management

lost $4 billion with currency and

interest-rate derivatives.



foreign currency or interest rates are going to

do,” he said, adding, “We haven’t been able

to identify reliably positive results of using a

perceived information advantage” enjoyed by

executives who speculate.

What is clear, however, is that shareholders

are generally in the dark about derivatives

speculat ion. “An important aspect of this study

is that we are able to assess whether investors,using publicly available data, could identify the

firms that admit to speculation in a confidential

survey,” Geczy and his colleagues write. “The

answer is that they could not.”

In the followup interviews, a number of firms

reported speculation was extensive enough

to potentially have a significant, or “material,”

effect on financial results. “In some cases, this

can be big,” Geczy said. But as the study notes,

the lack of financial statement transparency

about these activities is “not necessarily

evidence of accounting fraud, because actively

taking positions based on a market view may

not always meet the requirements for reporting

under generally accepted accounting principles

(GAAP). Nonetheless, irrespective of whether

opaqueness results because the accounting

rules do not require disclosure of speculative

activities or because firms do not implement

the rules properly, the end result is that the

financial statements do not provide an accurate

picture of the firm’s speculative activities.” ■

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