The Sarbanes-Oxley Act of 2002 and
Estimates To Complete (ETC):Why The CEO and CFO Must Care!
by
Gary HumphreysHumphreys & Associates, Inc.
And
Gary TroopC/S Solutions, Inc.
forThe 14th Annual International
Integrated Program Management Conference
November, 2002
Sarbanes-Oxley Act of 2002
What your bosses need to know about the Act and how it relates to realistic estimates-at-
completion (and potentially their paycheck).
Gary Troop
We are not attorneys! (but we did stay at a Holiday Inn Express
last night)
Disclaimer!!!
For legal advice see a real attorney. This presentation is intended to stimulate thought regarding the Oxley
Act and Earned Value Management
What Prompted the Oxley Act
• .COM Meltdown
• Enron
• WorldCom
• Stock Market Meltdown
• Loss of Investor Confidence in Financial Statements of Public Companies and their “Independent” Auditors
Quotes Regarding Oxley Act
• “Implements Sweeping Changes Affecting Corporate Governance and Disclosure, the Accounting Industry and Penalties for Securities Law Violations”
• “Could represent the most significant overhaul since the enactment of the Securities Exchange Act of 1934”
• “The Act will force many companies to adopt significant changes to their internal controls and the roles played by their audit committees and senior management in the financial reporting process”
Key Areas of Oxley Act
• Disclosures. The Act requires new or more expeditious disclosures and directs the SEC to issue rules requiring other disclosures.
• Audit Committees. The Act establishes new rules for the composition and duties of Audit Committees.
• Other corporate governance provisions. The Act also establishes new rules affecting other areas of corporate governance and provisions that will affect officer/director compensation and stock trading.
Key Areas of Oxley Act• New crimes and enhanced penalties. The Act
establishes new crimes and increases the maximum penalties for certain existing crimes.
• Provisions affecting securities or other civil litigation. The Act contains a few provisions that will or may affect private securities litigation.
• Federal regulation of auditing firms. A new entity called the Public Company Accounting Oversight Board will regulate and oversee auditing firms.
• Analyst Conflicts of Interest. The Act requires the SEC or SROs to adopt rules addressing conflicts of interest involving securities analysts.
Disclosures• Quarterly CEO/CFO certification of periodic
reports
• Quarterly CEO/CFO certification and report on internal controls
• Annual management report on internal control
• Financial statements must reflect auditors’ material adjustment
• Quarterly disclosure of off-balance sheet transactions
Disclosures• Other quarterly disclosures regarding finance-
related procedures: senior finance code of ethics, Audit Committee financial expert, and non-audit services provided by audit
• Disclosure of changes to or waivers of the senior financial officer ethics code
• Section 16(a) stock transaction reports within two business days, with next-business-day Internet posting by issuer and SEC
• Regular SEC review of disclosures
Certification by CEO/CFOExecutive Officers and Directors of Public CompaniesCertification of Financial Reports by CEOs and CFOs. The Act contains two divergent provisions requiring
certification by CEOs and CFOs of periodic reports filed with the SEC. Section 906 of the Act requires CEOs and CFOs to certify in each periodic report containing financial statements that:
1. the report fully complies with the requirements of Sections 13(a) and 15(d) of the Securities Exchange Act of 1934; and
2. the information contained in the report fairly presents, in all material respects, the company’s financial condition and results of operations.
3. Certifying officers of domestic public companies will face penalties for false certification of financial information of $1,000,000 and/or up to 10 years imprisonment if the violation was "knowing" and $5,000,000 and/or up to 20 years imprisonment if the violation was "willful."
4. In addition to the Section 906 certification described above, Section 302 of the Act directs the SEC to adopt rules, which must be effective no later than August 29, 2002, that will require CEOs and CFOs to certify in each annual and quarterly report filed with the SEC that
5. they have reviewed the report6. based on their knowledge
– the report does not contain any material misstatements or omissions and– the financial statements and other financial information included in the report fairly present
in all material respects the company’s financial condition and results of operations, and they have designed and reviewed the effectiveness of internal controls to ensure that they receive material information and they have disclosed to the audit committee any fraud and all significant deficiencies in the design or operation of the internal controls.
Sample Certifications
RaytheonLockheed MartinNorthrop Grumman
Disgorgement of CEO/CFO Compensation
Financial restatements arising from misconduct could result in disgorgement by the issuer’s CEO and CFO of bonuses paid to them and profits from their stock sales during the year following the original reporting of the results. There is no provision requiring that the CEO or CFO have any culpability in the misconduct. However, the Act permits the SEC to exempt any person from the application of this provision as it deems “necessary and appropriate.”
So What? And how does this relate to Earned Value?
Profit in a Project Based Business
• When do we know how much fee/profit was made on a given project?
• How does each project’s profit or projected profit roll into periodic financial statements?
• Why does an investor really care about the accuracy of profit projections?
When do we know how much fee/profit was made on a given project?
• Only when a project is completed do we know the actual profit
• Production Contracts are Usually Easier to Predict than Development Contracts
• Contract types impact the “exposure” to the company (Fixed Price, Cost Plus, etc.)
• Periodic “estimates” of profit must be made to support financial statements
• Estimates-at-Completion are done for each project with a portion of the total “estimated” profit allocated to the financial period
• The sum of all estimated profit for in-process work and actual profit for completed projects is determined for the period
• Risk Factors are Usually Applied• Investors typically do not have insight into the
details of individual projects; consequently, they rely on the financial statements for profit figures
How does each project’s profit or projected profit roll into periodic financial statements?
Sample Narrative from Financial Statements
RaytheonLockheed MartinNorthrop Grumman
Estimates To Complete (ETC):Why The CEO Must Care!
Gary Humphreys
What Is An ETC?
• Is it just another Earned Value Management System (EVMS) acronym?– ALL organizations perform ETCs– Some call them different names
• An ETC is a forecast of what it will take to complete all remaining tasks– Elements of cost required (Labor, material, ODC, etc.)– Time phasing of resources required (schedule)– Impact on company projected overhead costs
ETCs Affect The Company
• Profit impact on projects
• Company’s overall bottom line
• Impacts on image/reputation
• Investor/ stakeholder confidence
When To Conduct An ETC
• The initial proposal (first and most important)– Should be a REALISTIC assessment of all tasks– Establishes the Performance Measurement Baseline
• Customer: Minimum requirement - ETC annually• Company: Should require continual
reassessment– “Events” occur more frequently than annually– Allows more timely, proactive management action – Helps minimize future surprises– Risk Mitigation Plan Update
How To Ensure ETCs Are More Accurate
• Set proper ETC atmosphere– Encourage surfacing of real and potential
problems– Do not hide those problems at your level
• Honestly assess past performance problems– Do not “absolve sins” as you go with
Management Reserve (MR) misuse– Honest assessment is extremely difficult if
problems are masked– Do not borrow budget from future SOW to cover
current cost problems
Forgiving Sins As You Go
5093B
Cost /Schedule Variance Trends
Cost Variance +Sched VarianceMgmt Reserves
X
Cost Var @ Completion10% ThresholdsStart/Comp Date
-73.3
-8.88.1
-558.4-565.0
Years
300
200
100
0
-100
-200
-300
-400
-500
-600
-700
MR 1
MR 2
PMCONTR
+
X
+
+X
X
+
X
+X
DOLLARS
IN
MILLIONS
COMPLETE
START
Contract Completion ECD-1 ECD-2
© HUMPHREYS & ASSOCIATES, INC. 5093B
Cost /Schedule Variance Trends
Cost Variance +Sched VarianceMgmt Reserves
X
Cost Var @ Completion10% ThresholdsStart/Comp Date
-73.3-8.88.1
-558.4-565.0
Years
300
200
100
0
-100
-200
-300
-400
-500
-600
-700
MR 1
MR 2
PMCONTR
+
X
+
+X
X
+
X
+X
DOLLARS
IN
MILLIONS
COMPLETE
START
Contract Completion ECD-1 ECD-2
© HUMPHREYS & ASSOCIATES, INC.
Start
How To Ensure ETCs Are More Accurate
(continued)
• Honestly assess future conditions– Using honest assessments of past
performance (above)– Never sugar-coat or ignore potential impacts
• Keep your customers informed– Internal company executives– External customer
Common ETC Mistakes (Abuses?) That Affect The Company
• Denial• Delay• Magic• Manipulate• Borrow• Move• Confuse
• Let us assess the problem some more – do not report the ETC yet….
• Things will be OK after the award fee meeting, etc…
• The [boss/customer] does not tolerate any variances on this program
Common ETC Mistakes (Abuses?)
Denial“Surely We Can Fix That Problem!!”
• [Initial Plan/ Proposal] we will not win with that bid – cut the number by, say… 25%!!
• Delay the ETC long enough, they cannot cancel
• Why worry about doing a good ETC – the customer will surely provide more money
Delay Put Off The ETC So They Do Not Cancel The Program
Common ETC Mistakes (Abuses?)
Delaying The EAC
Time 2
5439A
Contract Schedule
Date
BCWP
ACWP
Original Baseline BCWS
Slip
Time 1
Slip
Original TAB = CBB
Time Now
True Trend
© HUMPHREYS & ASSOCIATES, INC.
EAC 2
EAC 1
EACTRUE
Profit
Required Performance 1
Required Performance 2
Common ETC Mistakes (Abuses?)
MagicMake Negatives Sound Positive To Management
(Not Unlike Current Business Headlines!)
– Showing ETC/ ECD growth as “increased sales/ profits”
– Faulty rationale: Since our costs are higher, we are obviously ahead of schedule!
– We have a “Level Of Effort” contract: so we must spend more to earn the fee!
Common ETC Mistakes (Abuses?)
$
Contract Cost
Original Baseline (BCWS) and FFPACWP Reported
BCWP
True Costs
Cost
Fixed Fee
Time Now Schedule Extension
ContractCompletion
Date
© HUMPHREYS & ASSOCIATES, INC.
Firm Fixed Price
Profit
Loss
Price
Realistic EAC
Common ETC Mistakes (Abuses?)
“Optimistic”EAC
Cost Plus Fixed FeeCustomer Will Provide More Money!
$
TIME
CONTRACT BUDGET BASE (CBB) = 165
Original Baseline (BCWS)
BCWP
ACWP
BACFixed Fee Amount
Time Now
Schedule Extension
ContractCompletion
Date
© HUMPHREYS & ASSOCIATES, INC.
Contract Price
Contract Funding To Cover Overruns
Common ETC Mistakes (Abuses?)
Fee Paid
Remaining Fixed Fee To Be Paid
Same Fixed Fee Amount – Smaller %
Cost Plus Incentive or Award Fee CPIF/ CPAF
+
5091
Contract Performance
BCWS +BCWPACWP
XTarget
Price w/ Base FeePrice w/ Possible Award Fee
1171.51165.11670.1
1200.01260.01320.0
Years
1200
1000
0
X
+
© HUMPHREYS & ASSOCIATES, INC.
DOLLARS
IN
MILLIONS
START
Contract Completion ECD-1 ECD-2
5% Base Fee
5% Possible Award Fee
1400
Common ETC Mistakes (Abuses?)
• Restart from “0” at the end of each year– Routinely wiping out CV and SV by setting BCWS
and BCWP equal to ACWP and re-planning – Artificially set SPI and CPI equal to 1.0 (“all is well
again!!”)
• Company mandates SPI and CPI “must be” 1.0– Encourages “playing with the numbers” – Invites artificially “Bumping Up” Earned Value
ManipulateMake The Numbers “Look Good”
-- Hide Performance Problems
Common ETC Mistakes (Abuses?)
• Destroys the scope/ schedule/ budget integrity
• “Robbing Peter to pay Paul” – Hides current performance problems using budget
intended for other work– Future tasks left with insufficient budget (or none)
• Fosters mistrust and poor estimates in general– Encourages “fatter estimates” by those “robbed”– Poor estimators continue to estimate the same way
as always
Borrow “Use Future Budget” For Current Work
Common ETC Mistakes (Abuses?)
2005
2002
• Makes current schedule condition “look good”– Is only an artificial picture– Changes your sequence of activities for work– Actually delays surfacing of problems– Adds pressure on out year performers/ resources
• Creates a “bow wave” of work to do– Typically, schedule relief is not requested/ granted– Strains resources in future– Creates an unachievable mountain of work
Move Shift Current Work To Future Years
Common ETC Mistakes (Abuses?)
• Both parties understand the contractual goals will not be met – Implementing an OTB/ OTS is NOT corrective action
• Contract Value DOES NOT CHANGE• True Efficiency Does Not Change
– OTB/ OTS action forgives nothing• This will be evident at Award Fee Time• The Truth Just Gets Harder To See
ConfuseLet’s Do An OTB/ OTS (Formal Reprogramming)
Common ETC Mistakes (Abuses?)
Summary: Impacts of Mistakes
• Poorly Developed ETCs Restrict Management By– “Compensating” for poor performance – Hiding problems – Artificially changing performance indices– Encouraging “manipulation” by lower levels– Hindering “drill down” capability
• You begin to believe the artificial conditions– Faulty sales and profit forecasts– Flawed resource forecasts and overhead projections– Managers Cry: “I did not know/ I was not told!” When
bad news surfaces
Contract XYZ Cost $100,000,000
Impact on Bottom Line
FFP Fee 12% $12,000,000
FFP Price $112,000,000“EAC” $ 97,000,000
Forecast to Stockholders
XYZ Profit Forecast = $15,000,000
Financial Statement
Contract XYZ Expected Profit
Less Optimistic “EAC-2”
Optimistic “EAC-1”
FFP Price $112,000,000
Fee Forecast $15,000,000
FFP Price $112,000,000
“EAC” $ 99,000,000
Fee Forecast $13,000,000
Revised Forecast to Stockholders
XYZ Profit Forecast = $13,000,000
($2,000,000 less profit)
Trend-Based EAC (the truth?) FFP Price $112,000,000“EAC” $107,000,000
Fee Forecast $ 5,000,000
Revised Forecast to Stockholders
XYZ Profit Forecast = $13,000,000
($10,000,000 less profit!!)
(original EAC)
Contract XYZ Cost $100,000,000 (original EAC)
“Shocking Surprise” To Bottom Line
FFP Fee 12% $12,000,000
FFP Price $112,000,000“Surprise” Eventual Cost $114,000,000
Forecast to Stockholders XYZ Final Profit Forecast = ($ 2,000,000)
Financial Statement
Contract XYZ Expected Profit
Eventual Final Cost
FFP Price $112,000,000
Fee Forecast ($ 2,000,000)
FFP Price $112,000,000“EAC” $ 97,000,000
Forecast to Stockholders XYZ Profit Forecast = $15,000,000
Original Optimistic “EAC-1”
Fee Forecast $15,000,000
Loss
Unhappy Stockholders Will Want To Know:
“What Happened?” and “Why Were We Not Told Sooner?”
CEOs and ETCs
• ETCs are important business practices• Set the proper atmosphere for sound ETCs
– The truth is out there: Demand it– Do Not Shoot The Messenger– Reward Forthcoming Managers
• Help solve problems revealed – Do Not “Require” Unachievable Goals– Use the data "as is" to make sound management decisions
• Do not “help” improperly– Resist covering with MR or “borrowed budget”– Resist pushing problems out to the future
• Just “Looking Good” is NOT “Being Good”– Do Not Mandate Unachievable Goals– Be concerned when everything is quiet upstairs
ETC Lighthouse
Conclusion
• ETCs play a key role in Financial Statement preparation
• Sarbanes-Oxley Act of 2002 puts CEOs & CFOs at risk when:– performance management systems don’t
generate accurate and timely data– unrealistic ETCs are used for profit estimates
in Financial Statements
• Questions?