Text/HTML
Text/HTML
If you are a registered user please log in to see more postings.
 

The AAO Weblog covers accounting issues and current events as they relate the practice of investment analysis.

 
 
Author: Jack Ciesielski Created: 10/13/2006 2:54 PM
The AAO Weblog is a weblog published by Jack Ciesielski , dealing with accounting issues and news topics related to investment and finance.

This is getting to be a round-the-clock effort.

Shortly after the posting of the 77 restaters on Monday afternoon, these four firms announced lease restatements:

American Tower Corp.
Brown Shoe Co.
Smith & Wollensky Restaurants
Tractor Supply Co.


In that little cluster, there's representation from each of the most frequently-offending industries: restaurant, retail and cell towers. Still waiting for more variety, but you can't complain about the volume. All of them had problems with accounting for landlord incentives/allowances in their leasehold improvements, except for American Tower. Their problem was the mismatch of lives between depreciable improvements and lease terms.

No promises, but I will try to post a comprehensive list once a week on Fridays.

Last Friday morning, I recapped the list of known firms suffering from lease accounting dysfunction. Our work had captured 37 of them to date.

As the saying goes, two heads are better than one. The Wall Street Journal Online ran a recap of their own on Friday afternoon. Here's a link to the article by Siobhan Hughes, where they corraled 60 firms showing the disorder. Checking their list, we found companies missing from our list - and companies in our list not in the WSJ bunch.

Put them all together, along with some new arrivals today, and you have the following 77 firms.

Abercromie & Fitch
A.C. Moore Arts & Crafts
Albertsons
American Tower
AnnTaylor Stores
Applebee's International
Arris Group
Bakers Footware Group
Benihana
Big Lots
Borders Group
Brinker International
Buca
Build-A-Bear Workshop
CEC Entertainment
Champps Entertainment
Charming Shoppes
Cingular Wireless
CKE Restaurants
Cracker Barrel (CBRL Group)
Crown Castle International
CVS Corp.
Darden Restaurants
Denny's
Dollar General
Domino's
Emeritus
Fresh Choice
GAP
Global Signal
Gymboree
Hudson's Bay
Hypercom
Internap Network Services
J.C. Penney
J. Jill Group
Jack in the Box
Jos. A. Bank
Kohl's
Krispy Kreme Doughnuts
Landry's Restaurants
Lone Star Steakhouse
Lowes
Marsh Supermarkets
May Department Stores
McDonalds
Nextel Partners
Nordstrom
O' Reilly Automotive
Outback Steakhouse
Pacific Sunwear
Panera Bread
Peets Coffee & Tea
Pep Boys Manny Moe & Jack
P.F. Chang's China Bistro
Powell Industries
Red Robin Gourmet Burgers
Rubios Restaurants
Ruby Tuesday
Safeway
SBA Communications
Sears
Siebel Systems
Starbucks
Target
TJX Cos.
Total Entertainment Restaurant
Toys 'R Us
Tullys Coffee
United Retail Group
Ubiquitel
Wendy's
West Marine
Whole Foods Market
Wild Oats Markets
The Yankee Candle Company
Yum Brands


And I don't think we've seen the end of it yet. Wait until the 10-K's start to file in around mid-March, and the next cycle of earnings releases. I think that will have been a pretty reasonable window for firms in all industries to have completed their lease-checking.

Remember Charlie McCreevy? He's the European Union internal market commissioner who had been lobbying the IASB for greater EU representation at the IASB. Blogged about him here a few weeks ago.

Charlie's - and the EU's - position: the IASB, and the International Accounting Standards Committee Foundation (IASCF) that governs it should have a more, well, European flair. As Charlie said in the Financial Times, the“representation within the international standard-setter and within a public oversight body should correspond more appropriately to jurisdictions that directly apply the standards."

That stance, as the IASCF reviews its constitution, is another thinly-disguised volley in the battle of the European banks and the IASB. Stateside, we don't see it much - but there has been a war over derivatives accounting every bit as nasty and political as our own here in the States on stock option compensation. (The particular bone of contention is IAS 39 - quite similar to Statement 133 here.)

Charlie McCreevy, meet Paul Volcker.

Friday, Mr. Volcker addressed the Accounting Regulatory Committee of the European Commission in Brussels. He handily rebuffed Mr. McCreevy and the European Commission:

"The decision of the European Union to enforce International Financial Reporting Standards (IFRS) by law provided bold and constructive leadership toward the concept of international, rather than national or regional, standards. It does not, however, logically lead to a decision to overweight European representation on the Board or the Committee. The “end game”, after all, is the acceptability of international standards right around the world. I have cited the strong momentum in that direction. The clear corollary is that Japan, China, India, other Asian countries, South American nations and others also want their views and experience reflected in Committee and Board discussions.”
[Emphasis added.]

This morning, the Dow Jones Newswires reports that the EU will not be giving up easily. No comment from Mr. McCreevy - yet.

Fortunately for the IASB and its constituents, they've got Paul Volcker. What happens when he retires in a year? This will not be an easy post to fill.

I've weblogged a lot about this topic in the last few weeks. This would be a good time to pull together some of the data and some (perhaps) deeper thoughts and prognostications.

Data first. Here's a list of 37 companies to date who have announced that they have lease accounting dysfunction. Not all of them are restating past financials; some like Target, are simply catching up the errors in the current quarter because they aren't very signficant. I make no claims that this list is all-inclusive. (Yes, I know a table would be much more readable. Unfortunately, I have not advanced my knowledge of WordPress blogging software to the point where I can do this.)

Abercromie & Fitch
Benihana
Big Lots
Borders Group
Brinker International
Buca
CEC Entertainment
Champps Entertainment
Cingular Wireless
CKE Restaurants
Cracker Barrel
Crown Castle International
Darden Restaurants
Dollar General
Emeritus
Fresh Choice
Gymboree
J. Jill Group
Jack in the Box
Kohl's
Krispy Kreme Doughnuts
Lone Star Steakhouse
Lowes
McDonalds
Pep Boys Manny Moe & Jack
Powell Industries
Rubios Restaurants
Ruby Tuesday
Sears
Siebel Systems
Starbucks
Target
Total Entertainment Restaurant
Toys 'R Us
Tullys Coffee
Ubiquitel
West Marine


That's it for the data; thirty-seven companies doesn't sound like many, but it feels like it's been in the hundreds because of the Chinese water torture aspect of their arrival. One or two drips a day makes it feel like they've been in the news forever.

I suspect that the Chinese water torture may come to an end - and in its place, a dousing with a fire hose. Why? Several reasons. As I mentioned in the prior posting on Cingular, we're starting to see remedies for dysfunctional lease accounting emerge in an industry other than the restaurant and retail industries. (Don't forget Siebel Systems, another non-R&R lease restater.) The accounting principles governing leases don't apply to just real estate so it's entirely possible that more dysfunctional lease accounting could be uncovered elsewhere. Firms and auditors don't work in a vacuum. Once an issue has been uncovered, they'd be foolish not to check for exposure in their own house. (Or in their audit client's house.) This has certainly become a known issue.

I believe that accounting precision has been ratcheted upwards as firms go through their Section 404 reviews, and this may be what got the ball rolling on these issues in the first place. I can't see any reason for accounting precision to reverse.

There's another reason we could be awash in more lease accounting revelations. Don Nicolaisen's lease accounting letter was issued on February 7 - after some firms had already reported their most recent quarter. I think there could be quite a few retailers/restauranteurs alone that issued earnings before the SEC letter was issued, and after the initial lease restatement announcements in late November. They may be waiting until their first quarter earnings to complete their determinations of lease accounting compliance.

Where did it all begin? Impossible to know. The error amounts have certainly not been extreme, but they're enough to make you wonder if they weren't part of the "get every penny of EPS" mentality that we've observed over the years. Like I said earlier: firms don't work in a vacuum. If one company adopted any of the improper lease techniques, you can be sure that its competitors would adopt it so as not to lose ground in comparison.

So, I think we can expect more lease accounting foolishness to be revealed. Take it with a grain of salt - rather than smoking gun evidence of financial chicanery, consider them to be a classic example of lowest common denominator accounting, the kind that happens when you try to be too much in touch with the rest of your competitors. It's like the kid who cheated in grade school by copying the test answers from his neighbor - and copied the answers his neighbor had wrong.

And as auditors sharpen their focus by learning more in their ongoing Section 404 reviews, I wouldn't be surprised to see more restatement waves for other accounting principles gone sloppy.

One of the odder lease restatements surfaced today: Cingular Wireless announced that they were going down the lease restatement path trod by so many retailers and restaurant firms. The financials from 2000 to 2003, and the interim financials for the first nine months of 2004 will be corrected. The cumulative pretax earnings tab: $171 million, mostly for the pre-2004 periods, and mostly related to rental expense.

You're probably thinking the same thing I did when I first heard it: "Must be the operating leases on their storefronts." Guess again. Cingular's lease issue related to its cell sites - which indicates that the lease restatements are spreading beyond the restaurant and retail industries. Obviously, those two industries are the most likely to have exposure to operating leases, but the Cingular restatement is a reminder that storefronts aren't the only assets firms might lease - and that the lease treatment can be wrong in other industries and for other assets as well. And also, to my surprise: Cingular isn't the first to have cell site leases wrong. (It's just the first one I noticed.) There have been a couple others in recent weeks: Ubiquitel from two weeks ago, and Crown Castle International last week.


There's no exemption for bad lease accounting just because a firm is not a retailer or restaurant. I don't think that this will be the last lease restatement we'll see outside of those two industries. (More about this posted here.)


Getting back to details: Cingular's lease errors revolved around the life chosen for recognizing rental expense. Apparently, they'd chosen the initial term of the lease as the period over which they recognized their rental expense, when in fact they should have taken into account the renewal periods as well - with their attendant rent escalations. Figuring those escalations into the total rent pot and straight-lining it over the entire period gives a higher rent expense than was recognized in the initial lease term years. There were also issues tied to the useful lives of leasehold improvements.

Aside from the February 7 letter from the SEC, there was another possible provocation for Cingular's restatement: its network infrastructure venture with T-Mobile USA, Inc., accounted for under the equity method, decided to correct its previously reported operating leases and useful lives.

Earlier this month, the SEC announced they'd sponsor a roundtable for soliciting comments about the experiences of registrants, auditors and unnamed others related to the Sarbanes-Oxley Section 404 reviews.

Mark your calendar. The date's been set: April 13, 2005. The roundtable should be interesting; what comes out of it should be much more interesting.

The Financial Times ran a story today headlined "A case of pension deficit disorder." Hmmm.... sounds vaguely familiar. Could they have gotten that phrase maybe from - here?

An excerpt:
"Attention is also being paid to the Financial Accounting Standards Board and the International Accounting Standards Board, amid a debate over the need for changes to pension accounting rules to force companies to better fund their plans.

Any proposal that required a closer marking to market value of pension assets would be likely to increase investment in longer-dated bonds.

Joseph Shatz, senior government bond strategist at Merrill Lynch, said many pension funds had “over-invested” in equities because current rules accounted for the investments in terms of long-term expected returns, not realised gains.

A move to mark-to-market could produce huge balance sheet swings unless neutralised by a shift into longer-dated bonds to better match assets and liabilities. (Emphasis added.)

“If the pension reform proposals are passed by Congress, the accounting reforms are more likely to be enacted by FASB and IASB,” added Mr Shatz.

Pension fund managers are already in a vicious circle as yields on longer-dated bonds, and coupons on new paper, have fallen even as the desire to more closely match assets with liabilities has boosted funds' appetite for longer maturity debt."

There's no denying that the pension accounting is in need of reform, both at the funding level which can be commanded only by Congress, and at the reporting level, which can be remedied by FASB and IASB.

At this time, the FASB has not yet added pension accounting to its agenda. In my view, it would be a good choice for them: the issues have been with us for years, and structurally, they're not getting better. Sure, assumptions are getting saner, and investors are wise to pension games played. But the same goofy mix of ingredients works its way into pension cost.

What's ironic about the article: before the Board has even added the project to its agenda, it's being damned for causing a rise in long bond rates. I'll bet the Board didn't know it was that powerful.

Doesn't anyone think that if demand rises for bonds at the long end, the Treasury might find a way to start issuing 30 year bonds again?

Enough retailer lease issues, already...

Countrywide Financial filed an 8-K this morning for the purpose of informing investors not to rely on their 2004 interim financial statements. And thankfully (for those who are interested in these kinds of things), it had nothing to do with the lease treatment of its loan offices. This non-reliance notice revolved on Countrywide's gains recognized in connection with securitizations.

Nothing terribly conspiratorial; nothing like bogus default rate assumed or silly prepayment assumptions. An excerpt here, with a little interpretation, might be helpful to explain what happened and why restatement was needed:

"Throughout 2004, Countrywide created certain mortgage-backed securities which were underwritten by the Company's affiliate, Countrywide Securities Corporation (“CSC”). These securities contained embedded derivatives designed to protect rated security holders from extreme changes in short-term interest rates and/or to enhance the credit rating of the securities. At the end of each quarter in 2004, a small amount of these securities had not yet been sold by CSC. The securities held at each quarter end during the year ranged from 0.1 percent to 2.2 percent of the principal balance of the related loans securitized. In all cases, the remaining securities were sold shortly after quarter end."

[Hang onto those italics; they're important for what happened. ]

"The Company believed that recording these transactions as sales fully complied with all applicable accounting principles. On February 18, 2005, Countrywide's independent auditor, KPMG LLP, informed the Company that all securities that contained embedded derivatives needed to have been completely sold before any portion of the sale could be recognized. In light of this information, the Company revised its recognition of gain on sale accordingly. This revision is based on an interpretation of Statement of Financial Accounting Standards No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” which provides standards for gain on sale accounting."

The thinking of the auditors, in their interpretation, probably went along these lines: if the company sold a batch of securities, all covered by the same embedded derivative/agreement to make holders whole in the event of those "extreme changes," then the firm (CSC) still has an ongoing relationship to the items sold if it's still retaining an interest in the securities. That may be the way the contract between CSC and the securitization trust was structured. Therefore, a genuine sale hasn't occurred - there's still an umbilical cord between CSC and the securities. Only when all of the securities are sold, is the cord completely cut.


"This revision will result in the reporting of a material weakness in internal controls over financial reporting in the Company's Form 10-K for the period ended December 31, 2004. The Company has modified its securities distribution practices so that it will not retain any securities that contain embedded derivatives at each quarter end. In addition, at each future period end, the Company will review its inventory of securities to confirm that no such securities remain in inventory. The cost of this remediation is insignificant."

So there's a financial reporting internal control issue too: if a certain kind of transaction doesn't qualify as a sale, financial statements aren't supposed to go out the door including them as sales. And I'd agree with the company: the cost of the remediation probably is insignificant.


No word in the 8-K on the size of the gains. Wait for the 10-Q/As.

Fannie Mae released news today on their ongoing examination by the Office of Federal Housing Enterprise Oversight. Oddly, there was no mention of the progress on the OFHEO website. Asymmetrical information.

While Fannie reported its progress on climbing out of its "undercapitalized" hole by September 30, 2005, you have to be slightly skeptical: the restatement of its financials is not yet complete, so how badly undercapitalized might it really be? Or looking at it the other way, depending how the accounting issues play out: is it as undercapitalized as it seems right now?

This sobering excerpt from the press release:

"OFHEO also has notified Fannie Mae's Board of Directors and management of several accounting and internal control issues and questions the agency has identified in its ongoing special examination, and directed that these matters be included in the internal reviews by Fannie Mae's board and management and reviewed by the company's external auditor. OFHEO indicated that it has not completed its review of all aspects of these issues, but has identified policies that it believes appear to be inconsistent with generally accepted accounting principles as well as internal control deficiencies that it believes raise safety and soundness concerns. The issues and questions pertain to the following areas: securities accounting, loan accounting, consolidations, accounting for commitments, and practices to smooth certain income and expense amounts. OFHEO also raised concerns regarding journal entry controls, systems limitations, and database modifications, as well as new developments relating to FAS 91."

Well - what's left? Not to throw cold water on Fannie's capital improvement plans, but all of these accounting issues really relate to the fundamentals of how Fannie makes her bread. Take a look at the summary of issues and questions in the press release: you've got your Statement 115 issues. You've got your Statement 140 (securitizations) issues. You've got your Statement 65 (mortgage banking activities) issues. You've got your Statement 149 & 133 matters (derivatives). You've got more of your Statement 91 issues (interest income recognition - already a known problem of unknown proportions). And for good measure, throw in issues on timing of recognition of certain income and expense amounts.

The true under-or-overcapitalization of Fannie Mae won't be known until this examination is complete.

Yesterday, I gave a talk at the New York Society of Security Analysts on "Accounting Trends and Issues for 2005." It was such a courteous crowd, everyone managed to stay awake. And this was a breakfast meeting.

Seriously, I had a great time: good questions, lots of interaction. The kind of stuff that makes it worth doing. If you care to, you can read the talk here.