528 Making Key Strategic Decisions Internal Control In addition to its opinion on the financial statements, the outside auditing firm writes a “management letter.” This letter lists possible weaknesses in the com- pany’s control system that have come to the auditor’s attention, together with recommendations for correcting them. (In the boilerplate preceding this list, the auditor disclaims responsibility for a complete analysis of the system. The listed items are only those that the firm happened to uncover.) Internal audi- tors also write reports on the subject. Audit committees follow up on these reports by asking management to respond to the criticisms. If management disagrees with the recommended course of action, its rationale is considered and is either accepted or rejected. If action is required, the committee keeps the item on its agenda until it is sat- isfied that the matter has been addressed. If an especially serious problem is uncovered, the committee may engage its public accounting firm or another firm to make a special study. If the prob- lem involves ethical or legal improprieties, the committee may engage an out- side law firm. As soon as material problems are identified, they must be reported promptly to the SEC on Form 8-K. The audit committee has a difficult problem with internal audit reports. In the course of a year, a moderate size staff may write 100 or more reports. Many of them are too trivial to warrant the committee’s attention. (One of the authors participated in an audit committee meeting of a multibillion dollar company in which 15 minutes were spent discussing a recommendation to improve the computer system that was expected to save $24,000 annually.) Drawing a line between important reports and trivial ones is difficult, how- ever. A rule of thumb, such as, “Tell us about the dozen most important mat- ters,” may be used, but what if the thirteenth matter also warrants the committee’s attention? In its private meeting with the head of internal audit, the audit commit- tee assures itself that the CEO has given the internal audit staff complete free- dom to do its work. The committee also makes it clear that the head of internal audit has direct access to the audit committee chair if a situation that warrants immediate board attention is uncovered. The internal auditor normally would report the matter in question to his or her superior first, but the auditor’s primary obligation is to the audit committee. The committee, in turn, should guarantee, as well as it can, that the internal auditor will be fully protected against possible retaliation. Internal Audit Organization The audit committee also considers the adequacy of the internal audit organi- zation. Is it large enough? Does it have the proper level of competence? For ex- ample, do the auditors know how to audit the latest computer systems? In many companies, the internal audit organization is a training ground where promising The Board of Directors 529 accountants are groomed for controllership. The audit committee may find it useful to get acquainted with the internal audit staff, as a basis for judging future candidates for the controller organization. When campaigns to reduce overhead are undertaken, the internal audit staff may be cut more than is healthy for the organization. The audit committee questions such cuts and gets an opinion from the outside auditing firm. How- ever, because internal auditors do much of the verifying that otherwise would be done by external auditors, at a much lower cost per hour, external auditors may not have an unbiased view of the proper size of the internal audit organization. FINANCE COMMITTEE The board is responsible to the shareholders for monitoring the corporation’s financial health and assuring that its financial viability is maintained. The fi- nance committee makes recommendations on these matters. (Nevertheless, as emphasized earlier, the full board cannot escape its ultimate responsibility for making sound decisions on important matters.) The committee’s agenda includes analyses of proposed capital and operat- ing budgets and regular reviews of the company’s financial performance as re- ported on the income statement, and its financial condition as reported on the balance sheet. The committee reviews the estimated financial requirements over the next several years and looks at how these requirements will be met. It also recommends the amount of quarterly dividends. The finance committee (or a separate pension committee) reviews matters of the pension fund as well as those of the fund for paying health-care and other post-employment bene- fits. It reviews the policies that determine the annual contribution to these funds and the performance of the firm or firms that invest them. This section describes aspects of these matters that are dealt with at the board of directors level. Reviews of performance and status are described in Chapters 1 and 2. The budget preparation process is described in Chapter 6. Financial policies are discussed in Chapters 9 through 13. In some companies, the functions described here are divided among three committees, for budget, finance, and pension, and the names may be different. Our purpose is to describe what committees do, regardless of their titles. Analysis of Financial Policies Financial policies are recommended by management. Tools of analysis are in- creasingly sophisticated. Using these tools to evaluate risk and return is the re- sponsibility of management, not the finance committee. These tools help to quantify risk, but they are not a substitute for a definite policy on risk. An atti- tude toward risk is a personal matter, and the finance committee should recog- nize it as such. Each CEO has a personal attitude toward risk, and so does each individual director. 530 Making Key Strategic Decisions The committee’s responsibility is to probe management’s rationales for its policies and thereby assure itself that management has thought them through and that the policies are within acceptable limits. Dividend Declaration One financial policy specifically for the board to decide is the declaration of dividends. Dividends are paid only if the company declares them; this declara- tion usually is made quarterly. Some companies regularly distribute a large fraction of earnings, while others retain a large fraction (or all) within the corporation. Although generous dividends may suit shareholders in the short run, they can deprive the corpora- tion of resources it needs to grow and thereby penalize shareholders in the long run. Conversely, if a large fraction of earnings is retained, shareholders may be deprived of the opportunity to make profitable alternative investments of their own. Thus, the finance committee must balance the interests of the cor- poration with the interests of individual shareholders. Some boards take a simplistic approach to dividends: “Always pay out X% of earnings,” or “Increase dividends each year, no matter what.” Both state- ments are acceptable guidelines, but neither is more than a guide. In some industries, a certain payout ratio is regarded as normal, and a company that de- parts substantially from industry practice may lose favor with investors. Good evidence suggests that a record of increasing dividends over time, or at least a record of stable dividends, is well regarded by investors. By contrast, an erratic dividend pattern is generally undesirable; it creates uncertainty for investors. Dividend policy warrants careful analysis. The principal factors that the board considers are: • What are the company’s financial needs? These needs depend on how fast the company wants to grow and how capable it is of growing. Or, as is the case with some companies, what is needed to preserve the company dur- ing a period of adversity? • How does the company want to finance its requirements for funds? It can meet its needs by retaining earnings, issuing debt, issuing equity, or some combination of these. Each source of funds has its own cost and its own degree of risk. • What return does the company expect to earn on shareholder equity, and what degree of risk is it willing to assume in order to achieve this objec- tive? The trade-off between risk and return will determine the appropri- ate type of financing and thus influence the extent to which earnings should be retained or paid out in dividends. These are complex questions. Moreover, the factors involved in arriving at answers to them interact with one another. Consider the example of Cisco Systems: The Board of Directors 531 Cisco was founded in 1984 and shipped its first product in 1985. The company grew rapidly. In 2000 it was a world leader in networking for the Internet, with sales of $18.9 billion and net income of $2.7 billion. The following statement is included in the company’s 2000 Annual Report. “The Company has never paid cash dividends on its common stock and has no present plans to do so.” Cisco re- tained all of its earnings to help finance its growth and used its stock to acquire other companies, which it integrated into its operations. Cisco’s dividend policy is typical of high-growth technology companies that need resources to grow but find raising equity in the financial markets ex- pensive because they have no financial “track record” for new ventures. Many successful companies have quite different dividend and financing policies from Cisco’s. Many public utility companies, for example, have long, unbroken records of stable dividends that are a relatively high percentage of earnings, ranging from 50% to 90%. Even during the Depression in the 1930s many of these companies maintained their regular dividends, although divi- dends exceeded earnings in some periods. The contrast between Cisco Systems and public utility companies indi- cates the extent to which dividend policy depends on an individual company’s circumstances and needs. It also highlights the relationships between dividend policy, the company’s need for financing, and the methods that it selects in order to meet its financial requirements. Pension Funds The finance committee considers two aspects of pension fund policy: (1) the amount required to be added to the fund and (2) the investment of the fund. Size of the Pension Fund Most corporate pension plans are defined benefit plans. In deciding the size of the fund required to make benefit payments to retirees, directors tend to rely heavily on the opinion of an actuary. The actuary calculates the necessary size of the fund using information about the size and demographic characteristics of the covered employees, facts about the provisions of the plan, and assump- tions about the fund’s return on investment and probable wage and salary in- creases over time. (With available software, the company can make the same calculation.) There is no way of knowing, however, how reasonable are two key as- sumptions: the future return on investment and the future wage and salary payments on which the pensions are based. Since the actuarial calculations de- pend on the accuracy of these assumptions, the calculations should not be taken as gospel. Both of these variables are roughly related to the future rate of inflation, and the spread between them should remain roughly constant. That is, when one variable changes by one percentage point, the other variable also is likely to change by one percentage point. 532 Making Key Strategic Decisions Pension Fund Investments The most conservative practice is to invest the pension fund in annuities or in bonds whose maturities match the anticipated pension payments. Such a policy is said to “lock in” the ability to make payments. This works out satisfactorily for employees who have already retired, but not for employees who are currently working. If the latter group’s compensation increases at a faster rate than is as- sumed in the actuarial calculations, or if the plan itself is sweetened, the fixed return will turn out to be inadequate. Under a defined benefit plan, there is no sure way to guarantee that the cash will be available when it is needed. In any event, with such a conservative policy, the company gives up the opportunity to earn the usually greater return from an investment in equities. Most companies hire one or more banks or investment firms to manage their pension funds. Voluminous data are available on the past performance of these managers. However, an excellent past record is no guarantee of excellent future performance. A firm is a collection of individuals. Investment perfor- mance is partly a function of the individuals doing the investing, and the per- formance record may change when these individuals leave or lose their skills. For many years, when it was managed by Peter Lynch, the Magellan Fund was the most successful of all mutual funds. After Mr. Lynch left, the fund’s per- formance was not so huge (but was still above average). Performance is also partly a matter of luck. Some companies divide the pension fund among several managers, peri- odically compare their performance, and replace the one with the poorest record. This may spread the risk somewhat, but it does not guarantee optimum performance. Luck and the individual who manages the fund continue to be dominant factors. It is a fact that some managers are better than others. The fi- nance committee watches performance carefully. It is cautious about making changes based primarily on short-run performance, but it does so promptly when it is convinced that a better manager has been identified. The finance committee also decides on asset allocation investment poli- cies: how much in equities, how much in fixed income securities, how much in real property, how much in new ventures, how much in overseas securities, and the maximum percentage in a single company or industry. Companies must also provide for costs of health-care and other benefits of employees who have not yet retired. The problems of estimating these costs are similar to those for pension funds, but with the additional complication that healthcare costs continue to increase at an unpredictable rate. SUMMARY In doing its job, the board accepts certain responsibilities. It should: • Actively support the CEO, both within the organization and to outside parties, as long as the individual’s performance is judged to be generally satisfactory. The Board of Directors 533 • Discuss proposed major changes in the company’s strategy and direction, major financing proposals, and other crucial issues, usually as proposed by the CEO. • Formulate major policies regarding ethical or public responsibility mat- ters, convey to the organization its expectation that the policies will be adhered to, and ensure that policy violations are not tolerated. • Ensure, if feasible, that the CEO has identified a successor and is groom- ing that person for the job. • Require the CEO to explain the rationale behind operating budgets, major capital expenditures, acquisitions, divestments, dividends, person- nel matters, and similar important plans. Accept these proposals if they are consistent with the company’s strategy and the explanation is reason- able. Otherwise, require additional information. • Analyze reports on the company’s performance, raise questions to high- light areas of possible concern, and suggest possible actions to improve performance, always with the understanding that the CEO, not the board, is responsible for performance. • Assure that financial information furnished to shareholders and other out- side parties fairly presents the financial performance and status of the company. Assure that internal controls are satisfactory. • Replace the CEO promptly if the board concludes the executive’s perfor- mance is and will continue to be unsatisfactory. • Participate actively in decisions to elect or appoint directors. • Decide on policies relating to the compensation of senior management, including bonuses, incentives, and perquisites. Determine the compensa- tion of the CEO. Review recommendations of the CEO and ratify the compensation of other executives. FOR FURTHER READING American Bar Association Committee on Continuing Professional Education, Corpo- rate Governance Institute: ALI-ABA Course of Study Materials (Philadelphia, PA: American Law Institute, 2000). , Corporate Director’s Guidebook (Chicago, IL: ABA, 1994). American Law Institute-American Bar Association, Current Issues in Corporate Governance: ALI-ABA Course of Study Materials (Philadelphia, PA: ALI-ABA, 1996). American Society of Corporate Secretaries, Current Board Practices (New York: ASCS, 2000). Anderson, Charles A., and Robert N. Anthony, The New Corporate Directors (New York: John Wiley, 1986). Bawley, Dan, Corporate Governance and Accountability: What Role for the Regula- tor, Director, and Auditor? (Westport, CT: Quorum, 1999). 534 Making Key Strategic Decisions Berenbeim, Ronald, The Corporate Board: A Growing Role in Strategic Assessment (New York: Conference Board, 1996). Bureau of National Affairs, Corporate Governance Manual (Washington, DC: Author, 1998). Cagney, Lawrence K., Compensation Committees (Washington, DC: Bureau of Na- tional Affairs, 1998). Cohen, Stephen S., and Gavin Boyd, eds., Corporate Governance and Globalization: Long Range Planning Issues (Northampton, MA: Edward Elgar, 2000). Davies, Adrian, A Strategic Approach to Corporate Governance (Brookfield, VT: Gower, 1999). Donaldson, Gordon, and Jay W. Lorsch, Decision Making at the Top (New York: Basic Books, 1983). Ernst & Young, Compensation Committees: Fulfilling Your Responsibilities in the 1990s (New York: Ernst & Young, 1995). Harvard Business Review on Corporate Governance (Boston: Harvard Business School, 2000). Investor Responsibility Research Center, Global Corporate Governance: Codes, Re- ports, and Legislation (Washington, DC: Author, 1999). Iskander, Magdi R., and Nadereh Chamlou, Corporate Governance: A Framework for Implementation (Washington, DC: World Bank, 2000). Keasey, Kevin, and Mike Wright, eds., Corporate Governance: Responsibilities, Risks, and Remuneration (New York: John Wiley, 1997). Knepper, William E., and Dan A. Bailey, Liability of Corporate Officers and Direc- tors, 6th ed. (Charlottesville, VA: Michie, 1998). Lorsch, Jay W., Pawns or Potentates: The Reality of America’s Corporate Boards (Boston: Harvard Business School, 1984). Mace, Myles L., Directors: Myth and Reality, rev. ed. (Boston: Division of Research, Harvard Business School, 1984). Montgomery, Jason, Corporate Governance Guidelines: An Analysis of Corporate Governance Guidelines at S&P 500 Corporations (Washington, DC: Investor Responsibility Research Center, 2000). National Association of Corporate Directors, The Role of the Board in Corporate Strategy (Washington, DC: NACD, 2000). , Report of the NACD Blue Ribbon Commission on Director Professionalism (Washington, DC: NACD, 1996). Oliver, Caroline, ed., The Policy Governance Fieldbook: Practical Lessons, Tips, and Tools from the Experience of Real-Word Boards (San Francisco: Jossey-Bass, 1999). Patterson, D. Jeanne, The Link between Corporate Governance and Performance: Year 2000 Update (New York: Conference Board, 2000). Stoner, James A. F., R. Edward Freeman, and Daniel R. Gilbert, Jr., Management, 6th ed. (London: Prentice-Hall International, 1995). Vancil, Richard F., Passing the Baton: Managing the Process of CEO Succession (Boston: Harvard Business School Press, 1987). Varallo, Gregory V., and Daniel A. Dreisbach, Corporate Governance in the 1990s: New Challenges and Evolving Standards (Chicago, IL: American Bar Associa- tion, 1996). The Board of Directors 535 Ward, Ralph D., Improving Corporate Boards: The Boardroom Insider Guidebook (New York: John Wiley, 2000). , 21st Century Corporate Board (New York: John Wiley, 1997). Weidenbaum, Murray L., The Evolving Corporate Board (St. Louis: Center for the Study of American Business, Washington University, 1994). NOTES 1. Kenneth R. Andrews, The Concept of Corporate Strategy (Homewood, IL: Dow-Jones Irwin, 1980). 2. SEC Release 34-41982. 3. Escott v. BarChris Construction Corp., 283 F. Supp. 643 (S.D.N.Y. 1968). 4. If the auditing firm cannot make this statement, it states that it is unable to give any opinion. In these circumstances, the stock exchanges immediately suspend trading in the company’s stock. 5. Investors Relation Business. Press release October 9, 2000. 536 16 INFORMATION TECHNOLOGY AND THE FIRM Theodore Grossman INTRODUCTION The personal use of information technology was discussed in an earlier chapter. This chapter will discuss the firm’s use of information technology. Of all the chapters in this book, the two dealing with information tech- nology will have the shortest half-life. Because of the constant flow of new technology, what is written about today will have changed somewhat by tomor- row. This chapter presents a snapshot of how technology is used today in in- dustry finance and accounting. By the time you compare your experiences with the contents of this chapter, some of the information will no longer be applica- ble. Change means progress. Unfortunately, many companies will not have adapted; consequently, they will have lost opportunity and threatened their own futures. HISTORICAL PERSPECTIVE To understand the present and future of information technology, it is impor- tant to understand its past. In the 1960s and 1970s, most companies’ informa- tion systems were enclosed in the “glass house.” If you entered any company that had its own computer, it was located behind a glass wall with a security system that allowed only those with access rights to enter the facility. One computer controlled all of a company’s data processing functions. Referred to as a host centric environment, the computer was initially used for accounting purposes—accounts payable, accounts receivable, order entry, payroll, and so on. In the late 1970s and 1980s, most companies purchased in-house Information Technology and the Firm 537 computer systems and stopped outsourcing their data processing. Recognizing the power and potential of information technology, companies directed the use of their technology toward operations, marketing, and sales; and they cre- ated a new executive position, Chief Information Officer (CIO), to oversee this process. In the 1980s, many companies gradually changed from host centric to dis- tributed computing. Instead of processing all of the information on one large, mainframe computer, companies positioned minicomputers to act as proces- sors for departments or special applications. The minicomputers were, in many cases, networked together to share data. Databases became distributed, with data residing in different locations, yet accessible to all the machines in the network. The personal computer had the greatest impact on the organization. It brought true distributed processing. Now everybody had their own computer, capable of performing feats that, until then, were only available on the com- pany’s mainframe computer. This created both opportunities and headaches for the company, some of which will be addressed in the section on controls. As companies entered the 1990s, these computers were networked, forging the opportunity to share data and resources, as well as to work in cooperative groups. In the mid-1990s, these networks were further enhanced through con- nection to larger, wide area networks (WANs) and to the ultimate WAN, the Internet. Companies are doing what was unthinkable just a couple of years ago. They are allowing their customers and their suppliers direct connection into their own computers. New technology is being introduced every day, and new terms are creeping into our language (Internet, intranet, extranet, etc.). It is from this perspective that we start by looking at computer hardware. HARDWARE Most of the early computers were large, mainframe computers. Usually manu- factured by IBM, they were powerful batch processing machines. Large num- bers of documents (e.g., invoices or orders) were entered into the computer and then processed, producing various reports and special documents, such as checks or accounts receivable statements. Technology was an extremely unfriendly territory. In many companies, millions of lines of software were written to run on this mainframe technology. Generally speaking, these machines were programmed in a language called COBOL and used an operating system that was proprietary for that hardware. Not only was it difficult to run programs on more than one manufacturer’s computer, but, because there were slight differences in the configurations and operating systems, it was difficult to run the same software on different com- puters, even if they were produced by the same manufacturer. In the 1980s, technology evolved from proprietary operating systems to minicomputers with open systems. These were the first open systems, . reports. Many of them are too trivial to warrant the committee’s attention. (One of the authors participated in an audit committee meeting of a multibillion dollar company in which 15 minutes. guide. In some industries, a certain payout ratio is regarded as normal, and a company that de- parts substantially from industry practice may lose favor with investors. Good evidence suggests. excellent future performance. A firm is a collection of individuals. Investment perfor- mance is partly a function of the individuals doing the investing, and the per- formance record may change