The CFO: from controller to global strategic partner.

What began as The Controllers Institute of America 75 years ago has evolved from a small group of 30 individuals to a group of many thousands; from controllers to senior financial executives and CFOs; and from a local to a global organization, Financial Executives International (FEI). Concurrently, the role of finance and the senior financial executive has also changed significantly. One need only note the name change of the organization to discover that!

The senior financial executive's narrow "accounting and control" function has expanded to one of a financial strategist and business advisor. Today's CFOs are expected to be extraordinarily broad-gauged, ranging from technical experts to strategic activists, acting in close alignment with their CEOs and boards of directors to satisfy the demands of a set of stakeholders that includes customers, employees, suppliers, communities and regulators, as well as shareholders. The journey has neither been a straight line nor constant. Some key underlying drivers of the change that has transpired in the financial executive role follow.

1930s to Post World War II

In the early 1930s, the U.S. economy was in the midst of the Great Depression. Major industries of that era--steel and other basic materials, railroads, automobiles and textiles--were running at low levels of capacity utilization, forcing firms to cut dividends and driving others to bankruptcy. The focus of the most senior finance executive, the controller, was on basic accounting and internal control of scarce funds.

Audited financial statements and external financial reporting were not required until January 1933, when the New York Stock Exchange (NYSE) initiated the requirement for audited financial statements of listed companies. That May, the Securities Act of 1933 was passed, requiring full disclosure to investors and prohibiting fraud in connection with the sale of securities.

One of the earliest contributions to accounting and control emanated in 1912 from E.I. du Pont de Nemours and Co., the "DuPont System of Return on Investment (ROI)," created by Donaldson Brown, who, in 1921, moved to General Motors Corp. as vice president of finance after DuPont had taken a large financial position in GM. He brought with him the ROI System that related profit margin to capital turnover.

At that time, the U.S. automotive market was divided--50-55 percent GM, 25-30 percent Ford and 10-15 percent Chrysler--and market leader GM used its ROI system to be the industry price-setter and set its prices based on its own costs, investments and volume projections to achieve a "desired" long-term ROI, thought to be 30 percent before taxes. Its ROI system eventually spread beyond the automotive industry, as the concept of relating profits to investment levels became generally accepted.

During the World War II years, U.S. manufacturing capacity was redirected toward the war effort, building ships, aircraft, tanks and other vehicles, and providing munitions and supplies to the Allied troops. When the war ended, the return to peacetime production and the release of pent-up demand resulted in rapid industrial growth. Returning troops, completing educations, starting families and moving to the suburbs, created new demands for home construction, highways, automobiles and other products including television sets. At the same time, the Marshall Plan in Europe and the U.S. occupation of Japan created demand for importing U.S. products, sowing the seeds for renewed global economic activity.

The 1950s

General Electric Co. (GE) had reached a size that prompted it to reconsider how it was organized, and it moved to a new "decentralized" structure. Its unique approach to decentralization created a set of divisions and operating departments below them, each with its own general manager responsible for his unit (all managers were then men). GE established a "measurement project"--including market share, productivity, product development, personnel development, community relations and financial performance--based on "residual income," to determine how to evaluate each unit. Residual income was defined as net operating profit after taxes (NOPAT) minus a "capital charge" based on the capital assigned to the unit multiplied by GE's weighted average cost of capital. Twenty years later, the measure became known as "economic value added," or EVA.

By the late 50s, senior financial executives were responsible for the accounting and control of their companies or, in the decentralized model, operating departments. Economic conditions were generally good, and competition was not a terribly critical issue. Banks and large financial institutions were the primary sources of capital, if needed. The utilization of capital was measured by ROI or, in the case of GE, also by residual income. Planning was relatively short-term and tactical.

The concept of "net present value of future cash flows" was in its infancy, particularly in industries with large investments and long payback periods, such as the oil companies. The first sets of "present value tables" were calculated by hand. The computer workhorse at the time--the IBM 1401--running company specific programs in batch processes in air-conditioned computer rooms, pales to today's laptops, with far more capacity and options. Companies had to report their financial results quarterly and audited results annually. They did not provide guidance or earnings estimates; there was far less pressure to "make numbers."

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The 1960s

The topics of management control and long-range planning systems were studied, written about and taught in leading business schools. Ross G. Walker and Robert N. Anthony at Harvard Business School defined the thinking for management control systems, distinguishing between revenue, expense, profit and investment centers--how to measure them, and when to apply them. Their work built on the previous practices at companies like GM and GE, while Richard F. Vancil and others--including this author--also at the Harvard Business School, began studying the long-range planning practices of major U.S. companies.

Most large companies were beginning to produce five-year plans, many of which were little more than extrapolations of their short-run budgets. Spreadsheet programs-Visicalc, Lotus 123 or Excel--were not yet developed, so multiple iterations of plans or "what if" analyses were difficult and limited. Business policy was taught in business schools as a capstone course, but the focus was primarily internal, relating the various functional areas such as marketing, production and finance to each other.

In 1964, Bruce Henderson started the Boston Consulting Group, one of the first significant strategy-consulting firms. Others, such as Bain and Co. and Braxton Associates, followed. In the late 60s, GE began to modify its long-range planning practices to be more strategic. And while it wasn't until the mid-to-late 70s that Michael Porter wrote on strategic planning, (and published his landmark book, Competitive Strategy), strategic planning was becoming an integral part of management practice. The focal point here within firms was often the senior financial officer.

Three other major currents were also underway. First was the impact of the U.S. efforts to rebuild Europe and Japan after WWII. Quality products from Europe, automobiles, for example, were introduced into U.S. markets. Low-cost products, such as textiles and light electrics, started arriving, and while German quality was considered high, "made in Japan" was interpreted as cheap. Principal adversaries during World War II became major industrial powers in the years and decades to come, and globalization was well underway.

Second, following the post-WWII economic prosperity, companies began to view their customer bases as more national and heterogeneous, and began to offer greater product variety. This proliferation of products and market segmentation had significant implications for the finance executive. More products drive the need to determine specific product costs and profitability; market segmentation drives the need to determine specific market costs and profitability; multiple products and more fickle customers result in shorter product life cycles, higher research and development costs and higher advertising and marketing expenses. Investment and operational analysis becomes more critical. Thus, management accounting, as well as financial accounting, became critical to the financial executive's responsibilities.

The third major trend was the emergence of the conglomerate. Until the 60s, companies tended to perform in relatively narrowly defined business categories, such as steel, automobiles, textiles, retailing and banking. Then, Textron Inc., Gulf and Western Co., Litton Industries Inc., Teledyne Technologies Inc., LTV Corp., ITT Corp. and other highly diversified acquisitions, were put together by leaders such as Royal Little, Charles Bludhorn, Charles Thornton, Henry Singleton, James Ling and Harold Geneen. Most deals were stock-for-stock transactions, accounted for using pooling-of-interests accounting. Integrating the acquisitions wasn't emphasized, as each acquired unit was evaluated on its own performance. If it did not perform satisfactorily, the theory was that it could be cut loose.

Harold Geneen, chairman and CEO of ITT, was then considered "the quintessential conglomerate executive." A former accountant, he was renowned for his lengthy monthly management review meetings, at which the operating heads of the various ITT units were grilled on the minutest details of their unit's performance. Unlike GE's decentralized model, all of the financial personnel in the ITT units reported directly to the corporate controller. The thesis was that this provided a strong check and balance on the line executives.

The generally strong post- WWII economy, the increased size of businesses, and the product, business, market and customer proliferation had increased the complexity of the financial executive's responsibilities. Domestic and foreign competition was increasing, and longer-range, strategic planning and stronger measurement and control of internal operations had become more important.

This era brought the senior financial executive into the search, selection, negotiation and pricing of the wide range of businesses that had been acquired. In cases when prior acquisitions were put up for sale, the finance executive was involved with the disposal process. With the array of decentralized divisions, longer-range strategic and shorter-range operational budgeting, coupled with the regular evaluation of performance, became normal practice. The senior financial executive became the orchestrator of the firm's planning, measurement, control and reporting process. As such, CEOs began to rely much more on their finance leaders as sources of firm knowledge and advice. The CFO's emergece as trusted advisor to the CEO and a critical part of the senior management team began.

The 1970s

Overall, it can be said that this was a period when senior financial executives had to consider, more than previously, the broader economic environment in which the firm operated, rather than just the narrow accounting, internal managerial accounting and financial reporting responsibilities. Globalization, heightened competition, financial volatility and uncertainty was making the CFO's responsibilities much more complex and challenging.

Many large U.S. companies were building or acquiring offshore operations to serve the emerging demands of Western Europe and other developing sectors around the globe. At the same time, European and especially Japanese companies were exporting more products to the U.S. The fixed rates of exchange that existed between foreign currencies were eliminated in the early 70s, resulting in increased foreign currency exchange risk. New financial instruments, derivatives, were created to deal with this challenge.

The strength of the U.S. economy throughout the 60s and early 70s resulted in large increases in wages and other costs, as well as increases in prices, driving the inflation rate up to double digits--higher than ever before in history. High inflation rates drove high interest rates, resulting in prime rates pushing 20 percent. Again, similar to currency risks, financial executives confronted with very high and volatile interest rates used derivatives, among other actions.

For financial executives, management of the firm's balance sheet took on increased importance as cash and short-term assets lost value quickly if excessive and not turned quickly. Stretching vendors, if possible, became more valuable. Hence, working capital management became more important. High levels of longer-term, fixed-rate debt became advantageous; where assets and liabilities were located also became a consideration; and measuring performance on an inflation-adjusted basis became important.

Also, in 1973 the Financial Accounting Standards Board (FASB) was established as successor to the Accounting Principles Board. FASB promulgated an accounting statement requiring companies to report their financial results, in their footnotes, on an inflation-adjusted basis. It was rescinded in the mid-80s, after inflation had dropped.

This was the beginning of the micro-computer revolution, and although the original micros had very limited capacity, the ability and potential they held for financial planning and analysis was huge for the financial executive, who now had a set of tools that permitted more far-ranging analysis than had ever been possible.

The 1980s

The efforts of the Federal Reserve to break the back of high inflation brought with it recession in the late 1970s and early 80s. Imports from Japan--especially automobiles and electronics--put additional pressure on the U.S. economy. The "Japan miracle," its ability to build high-quality products, quickly and at low cost, was a wake-up call for U.S. manufacturers who were threatened and challenged by the Japanese production model, originated by Toyota Motor Co. This author led a number of study missions to Japan for senior finance and accounting executives to benchmark both Japanese manufacturing and financial practices. One finding was that the Japanese provided performance results to the operations very quickly, at the end of each shift, rather than waiting for weeks or months to provide feedback, and results tended to be more operational than financial. Throughput measures of speed and quality levels were more important than detailed costs.

While Harley-Davidson Co. and Dell Inc. (among others) learned to compete, and even beat the Japanese, many U.S. manufacturers headed in an opposite direction by applying Activity Based Costing (ABC). Its underlying thesis is that simple methods of cost assignment, often using single overhead rates to assign costs to products and customers, led to inaccurate cost determination, product profitability and strategic direction. However, ABC only moved costs around without reducing them, and prevented U.S. manufacturers from improving their competitive position.

Also, Michael Millken and his colleagues at Drexel Burnham Lambert created the junk-bond market, providing financing to individuals and firms interested in taking over businesses with leveraged buyouts. Highly-leveraged businesses need to focus on generating cash to service the debt and their financial executives needed to understand the drivers of cash flow--expense control, short cash to cash cycles and stingy reinvestment practices.

The 1990s

Early in this decade there was considerable interest directed toward the idea of "the changing role of the CFO." It was suggested that the CFO and financial executives as primarily involved with transactions or as "cop" or controller did not go far enough nor create as much value for the firm as performing as "business partners." The view that financial information flowed from the units to the central office, rather than from the central office to the units, was seen as failing to capitalize on the center's financial expertise. Today, many consider the role of finance to consist of four activities: transaction processing, control, decision support and management activities.

The practice of "reengineering" emerged as a management emphasis, promulgated by Michael Hammer and James Champy (co-authors of Reengineering the Corporation). The concept was that there was (still) a lot of waste in many U.S. corporations, of which a good portion could be eliminated following a disciplined analysis of business processes. After acquisitions or decentralized units, companies found themselves with duplicate activities, so they set out to eliminate those deemed unnecessary, centralize common activities and outsource non-core activities to third-party providers.

For the finance function, many companies standardized IT platforms across the firm to simplify and accelerate consolidation processes and improve comparative analysis, and created shared services centers to centralize activities that had been organizationally dispersed. Finance executives were frequently at the center of these reengineering efforts.

With Netscape's 1994 initial public offering, the stage was set for many young, unprofitable (some had no revenues) Internet-oriented companies to be brought to market early in their existence. In many cases, valuations rose rapidly from the outset and reached levels far in excess of their traditional old-line competitors. Even warnings from the then-Fed Chairman Alan Greenspan of "irrational exuberance," failed to stem the rise of stock prices, valuations and market indices.

The emphasis on market values prompted many companies and their financial executives to redefine "profits." Many chose to emphasize their pro forma profits rather than adhere to generally accepted accounting principles (GAAP) definitions. Some described these pro forma profits as "excluding all the bad stuff." Others, and the financial analysts following them, chose to emphasize non-financial metrics as the basis for valuation. The pro forma practice became so widespread and difficult to calibrate that some years later the SEC required companies to reconcile any non-GAAP metrics to GAAP accounting.

Another significant financial reporting development was companies providing "guidance" to the analysts following their firms. Senior executives, the CEO and/or the CFO, would provide estimates of future earnings, usually in the context of an earnings conference call or analyst meeting; analysts estimates would be circulated to the financial press and TV business-news sources, and that number would become the target the company was expected to hit. A shortfall of even one penny per share could have a devastating impact on the market price of the company's stock. Unfortunately, pressure to meet estimates had the potential of causing firms to take short-term actions at the expense of longer-term results or, to make numbers by taking inappropriate actions.

There is little question that the decade of the 90s was a period during which many financial executives were particularly focused on external financial reporting, perhaps at the expense of internal accounting and control practices.

The 2000s

The stock market "bubble" burst during the first quarter of 2000 and, among other things, caused many of the highflying dot-com companies to go out of business. Enron Corp. imploded in late 2001 and went bankrupt, and WorldCom Inc. followed, in mid-2002. The spate of financial reporting "poster children" in the period of just several years prompted Congress to pass the Sarbanes-Oxley Act of 2002.

One requirement of the law is that the CEO and CFO certify their companies' financial statements, and second, that they certify that the company's internal controls over financial statements are adequate. Section 404, pertaining to internal controls, has resulted in companies, their financial organizations and their external auditors spending significant amounts of time and money during 2004 and 2005 to assure they are in compliance. In addition, the SEC has stepped up its requirements for "fair disclosure" and clarity of financial reporting.

The Future Role of the CFO

The financial executive has come a long way since the formation of The Controllers Institute of America in 1931. What was primarily an internal accounting and control responsibility has morphed into an extraordinarily broad and complex responsibility. Increased corporate size has led to new, decentralized forms of organizations, and with that, new challenges for planning and control. The proliferation of products and stratification of markets led to heightened needs for analysis. Fortunately, new technology and tools have been developed to enable detailed analysis.

Global markets have brought new opportunities and competitive challenges while competition has shortened product life cycles, resulting in higher development and marketing costs. Open currency exchange and volatile inflation and interest rates required new instruments to deal with them. The emphasis on shareholder value has put tremendous pressure on firms to perform, or run the risk of being taken over by others, using new sources and instruments of financing. Meeting "numbers" has become a major driver of CFO attention, as has a return to required assurance that internal controls are in place to assure quality financial reporting.

The CFO is at the crossroads of a firm's information and, as a result, a key source of advice and counsel to the CEO. Together, the CEO and CFO often represent the highest level of strategy formulation for the company. However, in addition, the CFO has the responsibility to assure that the plans are enacted and that the results are accurately and clearly presented to the investor community and others. Being a CFO today is a big job and a huge responsibility!

So, what does the future hold for the CFO? First, globalization will continue to be a major element of corporate direction, driving global sourcing and offshoring activities, as well as serving emerging markets. The CFO will have to be able to evaluate a host of alternative approaches with global implications and consequences.

Second, more firms will be relying on intellectual capital to drive success, rather than physical or financial capital. Investments in human capital and other intangibles will need to be managed and accounted for, in very different ways. Intellectual capital needs to be carefully selected, developed, maintained and accounted for as an asset, rather than effectively ignored. New focus and new metrics that consider all of the firm's key stakeholders--rather than just shareholders--will need to be developed, maintained and reported.

However, companies will still need to create value to continue to attract shareholders. Inasmuch as the intrinsic value of any economic entity is the net present value of the future cash flows which it will produce, financial executives must continue to focus explicitly on the cash flows the firm is producing. This should result in new, cash-oriented metrics and financial reporting.

The CFO has come a long way in 75 years. In the next 75, he and she are sure to see even more dramatic changes!

Dr. Robert A. Howell ([e-mail]) is a Distinguished Visiting Professor at the Tuck School of Business at Dartmouth College. He has been a business school professor for more than 40 years, a member of FEI for more than 30 years, a member of Financial Executive's Editorial Advisory Board and a frequent contributor to Financial Executive.

RELATED ARTICLE: How FE Tracked the Emergence of the CFO

The emergence of the C-level senior finance position "chief financial officer" (CFO) occurred in the mid-1960s. Below are a few examples of the print coverage given by Financial Executive (FE) in the earlier days:

* January 1966: Results of a Heidrick & Struggles Inc. survey is published in FE on the education, experience and birthplace of financial officers. "Postscripts to Profile of a Chief Financial Officer."

* May 1968: Remarks by President of Lockheed Corp. A. Carl Kotchian to the FEI Los Angeles chapter, reprinted in FE, "A President's View of a Chief Financial Officer."

* March 1970: A survey of Fortune 500 companies was published in FE, "Who Controls Finance in the Industrial Giants?" The survey, conducted by James Krum, assistant business professor at the University of Delaware, discusses use of the title CFO among financial officers, who can also be the treasurer, controller or vice president-finance.

* July 1976: "The Growth of the Corporate Finance Function," by Lawrence W. Hill, vice president and director at Heidrick & Struggles Inc., opened: "Today's CFO is responsible for cash controls, bank relation, financing, tax accounting and custody of assets. His role has become primarily one of forecasting and planning, not budgeting and reporting."

* August 1979: "Danger Ahead for CFOs--Pension Fund Assets are Fast Catching Up to Corporate Worth," by Paul N. Wilson, executive vice president, Fidelity Bank.

* March, 1983: "A CFO's Guide to Corporate Advancement," by Lawrence P. Klamon, president, Fuqua Industries Inc., highlights why CFOs make good candidates for the CEO position.

--complied by Cynthia Waller Vallario