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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.

We're doing things a little differently today.

You may have noticed that the weblog postings have been a little light in the past week. (I hope you still find them useful, though.) That's because I've been working on a major report for The Analyst's Accounting Observer, which is what pays the bills. It's one of those pieces that requires total immersion, or it never gets done. And being as how the report dealt with stock options and restricted stock in the S&P 500, I was anxious to get it done as soon as possible.

So, lately, I have not been able to keep my accounting antenna very high. And my office looks more like a giant rat's nest than usual, filled with stuff that's been put off over the last couple of weeks THAT MUST BE ATTENDED TO NOW. So, I hope to clear it up in the next day or two and get back to a normal level of weblogging. Soon.

Anyway, about the lease restater roll call: just a quick update. Only seven new faces this week: Ace Cash Express, Alberto-Culver, Allied Domecq, Alltel, Bebe Stores, Kelly Services, and Wet Seal. That brings the total up to 268. No complete update today, just the names.

The pace has definitely slowed down. Unless things pick up again, I will be posting the complete roll call only twice a month - at mid-month and at month-end. Let's hope that soon there's no reason to continue posting it at all.

On April 14, the SEC overrode the FASB on the implementation of Statement 123(Revised), making it effective for calendar year registrants in 2006, while fiscal year filers still had to implement it.

Prior to the SEC's interference, there had been a run on accelerating the vesting of underwater stock options: managements clearly had wanted to eliminate as much future expense as they could. They coaxed their boards into approving early vesting acceleration to push all the associated option compensation into the footnotes before Statement 123(Revised) went effective.

Once the SEC's action was announced, there was a decrease in the volume of companies hitting the accelerator. They might be postponing work they intend to do later; or they might believe that the SEC's action might lead to a more permanent ditching of the standard.

A week after the SEC's interference, however, a couple of smaller firms announced accelerations: one which made complete sense (from the point of view of someone trying to evade accountability, that is), because it has a June 30 year end and will have to employ Statement 123 (Revised) quite soon. That firm was little SBS Technologies. Interesting phrasing in their 8-K on the rationale for the move: "In response to SFAS 123R, on April 21, 2005, the Board of Directors of SBS approved the acceleration of the vesting of all outstanding unvested stock options with an exercise price greater than $9.22 (the Acceleration)...SBS' decision to accelerate the vesting of these options was in anticipation of compensation expense to be recorded subsequent to the effective date of SFAS 123R on July 1, 2005 in connection with outstanding unvested stock options issued to employees."

No bones about it. "We did it because we don't like 123R."

The other acceleration took place on the same day as SBS Technologies' at somewhat larger Sinclair Broadcast Group. And their rationale was almost as forthright: "The decision to accelerate the vesting of all unvested options, which the Company believes to be in the best interest of its shareholders and employees, was made primarily to reduce compensation expense that would have been recognized in future periods following the Company's adoption of Financial Accounting Standards Board Statement No. 123, “Share Based Payment (revised 2004)” (“FAS 123R”)... The acceleration of vesting will reduce the Company's compensation expense related to these options by $0.8 million (pre-tax) in aggregate for the years 2006 through 2008, the original remaining vesting period."

Every penny counts. At least when it comes to not recording compensation expense.

Will companies continue their acceleration binge? There'll probably be a steady stream of the fiscal year companies accelerating them; there's yet to be acceleration news from one of the really big fiscal year "expensing opponents" like Cisco. If something like that happens, there's bound to be a flood of "me too" actions. For now, though, it looks like the calendar year companies are taking a rest - Sinclair, so far, is an outlier. Maybe the calendar year firms will continue to rest until the fourth quarter, if it looks like Statement 123R is going to live. And a lot of that will depend on how well HR 913 does between now and the end of Congress.

Yesterday, Deloitte announced its settlement with the SEC for its role as auditor in the Adelphia Communications and Just For Feet frauds. That press release is quite a bit different in tone from the SEC's release on Adelphia and Just For Feet; it all depends on your point of view.

The Deloitte version of the event focuses on "global" blame. According to Deloitte USA CEO James Quigley: “These cases raise a larger issue facing the auditing profession. Among our most significant challenges is the early detection of fraud, particularly when the client, its management and others collude specifically to deceive a company's external auditors. Deloitte & Touche LLP has implemented, and will continue to implement, a number of additional improvements in its policies and procedures for auditing clients in its risk management program and to aid in uncovering fraudulent activity in a more timely manner.”

And the SEC was unsparing in its criticism of Deloitte's failings. Regarding Adelphia: "What is especially troubling here is that Deloitte recognized the risk of fraud posed by this client at the outset. When auditors turn a blind eye toward misconduct on a high-risk client and allow a fraud of this magnitude to go undetected, the consequences will be severe." Regarding Just For Feet: "Auditing firms and their personnel are responsible for exercising professional care and maintaining skepticism in auditing financial statements, particularly when the company is identified as having a high risk of potential fraud... Shareholders depend on auditing firms as a check on the honesty of management. They are expected to respond appropriately to wrongdoing, adequately test the claims made by management and complete the work supporting the audit before issuing an audit report."

That Deloitte press release is actually Round Two. The Wall Street Journal carries a very interesting account of the difference between the first version and the current one.

Yesterday, the SEC and the United States Attorney's Office announced a settlement of $715 million in the case of Adelphia Communications, to be paid to a victim's fund. The case of Adelphia was one of the largest financial frauds to take place in a public company; it's a testament to the strength of the underlying business that there was anything left to sell to Time Warner and Comcast.

Lest you forgot, a brief refresher of what went on at Adelphia's home base in little Coudersport, Pennsylvania, from the SEC news release: "Adelphia, at the direction of the individual defendants: (1) fraudulently excluded billions of dollars in liabilities from its consolidated financial statements by hiding them on the books of off-balance sheet affiliates; (2) falsified operating statistics and inflated earnings to meet Wall Street estimates; and (3) concealed rampant self-dealing by the Rigas family, including the undisclosed use of corporate funds for purchases of Adelphia stock and luxury condominiums."

Not the kind of stuff that outsiders could detect too well. And not the kind of stuff the auditor, Deloitte & Touche, detected too well. According to the Wall Street Journal, D&T will announce today the payment of a $50 million fine for failure to detect the ongoing fraud.

Next time you hear someone complain about current audit fees, keep this case in mind. If the auditors are truly auditing the client, it's worth paying up.

Things are heating up in the area of international convergence of accounting standards. SEC Chairman William Donaldson met with the European Union's chief of internal markets, Charlie McCreevy last Thursday: the topic was setting a timetable for the day when foreign filers no longer have to provide a reconciliation of their foreign-basis figures to U.S. GAAP amounts.

Their goal: to eliminate that requirement for foreign private issuers using International Financial Reporting Standards as early as possible between now and 2009 at the latest.

An admirable goal, and one that will take hours of review and haggling over adjusting US and IASB standards. SEC chief accountant Don Nicolaisen gave a speech at Northwestern University on the plans he and his staff have developed for making this happen - down to a detailed "convergence roadmap." If you're an investor, be grateful; you're going to be able to process more information with less effort once this is done. If you're an accountant with an interest in international reporting, be grateful too. Your job security is assured.

If you looked at this before 10:27 East Coast time, please take another look. The information about auditor changes has been pulled: please ignore it if you already saw it. It turns out that some of the auditor changes mentioned took place before the lease revision announcement. I hope to have it back next week in better form. And now... we return you to your regularly scheduled program. Another Friday, another Lease Restater Roll Call... Cumulative count through 4PM, Wednesday: 261. New faces in the line-up since last week include Dollar Tree, Goody's Family Clothing, KeyCorp, National City, Neiman Marcus, Regis Corp., RF Micro Devices, Sbarro, Sports Club Company, Stater Brothers Holdings, SuperValu, and Vimpelcom. The pattern remains pretty much intact: most new additions were retailers. But there was a little more variety than usual: two banks (KeyCorp, National City) and a health club operator (Sports Club Company). Award for outlier of the week goes to RF Micro Devices, the first semiconductor company to join the list. The firm's 8-K was spare on details about the nature of the lease corrections to be made. Industry categories: 144 retailers, 58 in the hospitality industry, 15 in the wireless telecom business, 7 real estate enterprises, 5 in banking/finance, and an assorted 32 others comprised the 261 total companies. Types of lease accounting errors: There were 155 instances of errors relating to rent holidays, 96 errors tied to construction allowances and 93 errors related to mismatch of lives or lease terms. (For a refresher on the different kinds of errors being reported, link here. For an explanation as to why "rent holiday" errors are most common, link here. ) Auditor headcount: When the lease accounting revisions were announced by firms, Deloitte & Touche were the auditors for 69 of them; Ernst & Young, the auditors for another 69 of them; PricewaterhouseCoopers was the auditor for 57 firms; KPMG, another 54 companies; BDO Seidman, 5 firms; Grant Thornton, 2 of the firms; and the remaining 5 firms were audited by non-national firms. Human costs: At least one CFO has had enough. Outback Steakhouse's CFO retires after "lunacy over lease accounting took me past the breaking point," reports the San Jose Mercury. Now, the main event: the 261 companies that have restated, made catch-up adjustments or are in the process of reviewing their accounting. The usual disclaimer: no assurances are given that this is the entire universe of lease-challenged companies; it's strictly a best-efforts attempt. Buca Denny's Harold's Stores Macerich Phillips-Van Heusen Stein Mart Buckle Deutsche Telekom Hastings Entertainment Main Street Restaurant Group Pier 1 Imports Stride Rite Buffalo Wings Dick's Sporting Goods Haverty Furniture Marlin Business Services Portola Packaging SuperValu Build-A-Bear Workshop Diedrich Coffee Healthcare Realty Trust Marsh Supermarkets Powell Industries Talbots Burlington Coat Factory Dollar General Heritage Commerce May Department Stores Ramco Gershenson Target Cache Dollar Tree Hersha Hospitality Trust McCormick & Schmick's Red Robin Gourmet Burgers Texas Roadhouse California Pizza Kitchen Domino's Hibbitt Sporting Goods McDonald's Regis TJX Cos. Cambrex Dress Barn Highwoods Properties Men's Wearhouse Restaurant Co. Too Carrol's Duane Reade Hollywood Entertainment Michael's Stores Restoration Hardware Total Entertainment Restaurant Cato Duckwall-Alco Stores Hot Topic Monro Muffler Brake RF Micro Devices Toys 'R Us CBRL Group EGL Hudson's Bay Morgan Stanley Richardson Electronics Tractor Supply CEC Entertainment El Pollo Loco Hypercom Mother's Work Rite Aid Tuesday Morning Ceridian Electronics Boutique IHOP Movie Gallery Ross Stores Tully's Coffee Champps Entertainment Emeritus Intelidata Technologies National City Rowe Companies (The) U.S. Unwired Charlotte Russe Equinox Holdings Internap Network Services Navigant International RTI International Metals Ubiquitel Charming Shoppes eResearch Technology Interpublic Group of Companies Nebraska Book Rubios Restaurants United Retail Group Cheesecake Factory Ethan Allen IWO Holdings Neiman Marcus Ruby Tuesday Urban Outfitters Chico's FAS Family Dollar J. Crew Group New World Restaurant Group S&K Famous Brands Vicorp Children's Place Retail Stores Finish Line J. Jill Group New York & Company Safeway Vimpelcom Christopher & Banks Forzani Jack in the Box Nextel Partners Saks Walgreen Cingular Wireless Fossil Jean Coutu Group (The) Nordstrom SBA Communications Warnaco Circuit City Fred's Jo-Ann Stores O'Charley's Sbarro...

Read More »

It's been a while since we tuned in the restatement channel, so let's pull away from the SEC settlement blitz for a bit. An interesting sort of non-reliance 8-K was filed yesterday by Doral Financial, a diversified financial services company. Nifty little company: it's the fourth largest commercial bank in Puerto Rico, and the largest mortgage banker there, too; it also has a presence in New York it's aiming to grow. At $15 billion in assets at year end 2004, it's not an insubstantial player. And being a mortgage banker, the firm employs loan securitizations to loosen up cash for further investment.

The reason for the non-reliance notice was due to the determination that the wrong interest rates had been used in estimating the fair value of the firm's floating rate interest-only securities. IOs, as they are known are extremely sensitive to changes in interest rate assumptions because, as their name implies, they aren't anything but interest. The firm decided that rather than using contractual rates or actual 90-day LIBOR rates at the end of each reporting period, it should be valuing the IOs with rates embedded in the forward yield curve. (Which makes sense: if you're trying to come up with a fair value for an IO, it would be logical to use the same interest rates the rest of the world would use - which is what's shown in the market's yield curve.)

Switching to the forward yield curve will make for an adjustment that will be reflected as a restatement of prior periods, not as a catch-up adjustment. And it might report a material weakness in internal controls as of year end 2004; the firm isn't sure yet.

Doral isn't the only firm to rethink its securitizations this year: it joins Countrywide Financial, Providian Financial and last but not least, Fannie Mae. Interest rates have been building this year, too; they might be forcing more critical reviews of securitization policies. Keep tuned.

You think about what happened a few years ago during the corporate meltdown of 2002, and you wonder "Whatever happened to the perpetrators? Or the auditors? What's the rest of the story?" The world now focuses on the Bernard Ebbers trial and the trials of assorted Enron characters, but there's been a lot of settling-up on other cases, as you're reminded in these postings: EasyLink, Chancellor, Global Crossing, and Coca-Cola.

The SEC tear continues... it announced yesterday that it settled litigation with KPMG for its audits of Xerox. [Heads-up disclosure: KPMG subscribes to The Analyst's Accounting Observer.] Total tab: $22.475 million. Of that amount, $9.8 million represents the KPMG audit fees from 1997 to 2000; $2.675 in interest; and a $10 million civil penalty. Ouch. What did they do to deserve such punishment?

According to the release, KPMG "willfully aided and abetted Xerox's violations of the anti-fraud, reporting, recordkeeping and internal controls provisions of the federal securities laws. The Order also finds that KPMG violated its obligations to disclose to Xerox illegal acts that came to its attention during the Xerox audits." How bad did it get?

Again, from the release: "KPMG permitted Xerox to manipulate its accounting practices to close a $3 billion "gap" between actual operating results and results reported to the investing public. During this period, Xerox used topside accounting actions at the end of financial reporting periods to increase equipment revenue and earnings through the improper acceleration of revenue from long term leases of Xerox copiers and through manipulation of excess or "cookie jar" reserves. Most of Xerox's topside accounting actions violated generally accepted accounting principles (GAAP) and all of them inflated and distorted Xerox's performance but were not disclosed to investors. These undisclosed actions overstated Xerox's true equipment revenues by at least $3 billion and overstated its true earnings by approximately $1.5 billion during the four-year period.

According to the Order, in each of the years 1997-2000, KPMG issued audit reports containing unqualified opinions stating that KPMG had applied generally accepted auditing standards (GAAS) to its review of Xerox's accounting, that Xerox's financial reporting was consistent with GAAP and that Xerox's reported results fairly represented the financial condition of the company." Which they did not.

This is an example of what I think of as "compliant auditing" - conforming to the wishes of the client - instead of "compliance auditing" - figuring out whether the audit client hewed to accounting standards in communicating with investors at large and its shareholders. And it makes me think of these windy sentences from yesterday's Wall Street Journal editorial "Sox And Stocks:"

"The greatest Sox irony is that its main beneficiaries are the same big accounting firms that the politicians blamed for Enron, WorldCom and the other scandals. The Big Four accounting firms audit the majority of public companies, and by some estimates up to 30% of 404 costs will be paid to these external auditors. Nice work if you can get it."

My question to those critics of the re-spined audit profession: what do you want? Compliant auditors like we had during the golden age of financial scamming - ones who used audits as loss leaders to get more lucrative business? Or a prickly, self-sufficient audit profession that acts like compliance auditors? I prefer the latter. If auditors are doing what they should, I have a hard time faulting them for making a buck while they do it.

Remember the "Broad-based Stock Option Plan Transparency Act" I mentioned yesterday, sponsored by California Representatives Dreier and Eshoo? There was a list of the bill's co-sponsors linked in the post.

There's one name not on the list of co-sponsors - but that doesn't make him a fan of improving accounting and accountability to shareholders. He's Senator John Ensign of Nevada, and he promises he "will continue to explore legislative options in an effort to preserve broad based employee stock options.”

Probably no idle threat. There's money to be found by supporting the tech lobby, so we might see a round of anti-shareholder "can you top this" bills surfacing over the summer.

Today the SEC and Coca-Cola announced the settlement of antifraud charges in connection with its channel stuffing escapades in Japan. The SEC has been on something of a tear lately: EasyLink, Chancellor, Global Crossing, and now Coca-Cola. The docket is emptying fast.

Between 1997 and 1999, Coca-Cola engaged in what it called "gallon pushing" (a more industry-specific term for "channel stuffing") on its Japanese bottlers. Typically, the amount of concentrate inventory on hand at bottlers matches the expected level of finished product needed at the retail level. Coke enticed the Japanese bottlers to buy more concentrate than they needed, by offering generous credit terms on the products. Instead of the normal eight days of credit, Coke offered bottlers up to thirty days to pay. At the end of 1999, the bottlers' inventory was 62% higher than at the beginning of 1997 its peak the growth in inventories. Comparable sales growth? 11%. That's some gallon pushing.

The products Coke pushed - Georgia Coffee and Coke - were two of the most popular Japanese beverages Coke sold, and two of the most profitable. Coke got the most bang for its gallon pushing buck in terms of meeting earnings estimates by focusing on these two. In the twelve quarters covered by the gallon pushing efforts, the income generated by the practice enabled Coca-Cola to meet consensus earnings in eight of those quarters.

It doesn't take a degree in beverage management science to see the problems Coke created for itself. By employing the flawed practice, the firm started off every quarter with a sales deficit - which could only be cured by more gallon pushing. The practice actually became ingrained into the firm's business plans - but investors couldn't tell. To them, hitting the earnings targets meant business as usual. According to the administrative proceeding, "At no time between 1997 and 1999 did Coca-Cola disclose any information from which investors could determine the existence of gallon pushing, the impact of such gallon pushing on current income, or the likely impact of gallon pushing on future income."

More misleading information: in January 2000, Coca-Cola management had had enough of gallon pushing and embarked on a program to lower worldwide concentrate levels. In an 8-K announcing the decision, management portrayed the decision as the end result of a joint review of inventory levels with its bottlers. It wasn't - it was a unilateral decision by Coke. Furthermore, while the 8-K mentioned the expected earnings impact of $.11 to $.13 in the first half of 2000, it neglected to inform investors that more than $.05 was due to the Japan bottlers - where the gross profit impact was over five times more significant than anywhere else in the world.

Call it what you want - channel stuffing, trade loading, or gallon pushing - it isn't illegal to induce your customers to buy more of what they don't need. (You could argue that inducing customers to buy what they don't need is a tremendously valuable skill practiced in most businesses.) It's not even a genuine accounting gimmick: the sales were genuine and complete. The bottlers had never returned the stuff, nor did they have the right to do so. (Coke is not restating any past financial statements, either.) It's a dumb practice, for sure: avoiding the consequences of a revenue shortfall puts the firm on a treadmill to keep doing more trade loading to maintain the facade of growth; it's borrowing from the future to make today look good, and sooner or later there's a reckoning.

What got Coke into the soup actually wasn't gallon pushing, per se. No, it was the fact that the practice had a significant effect on earnings and future earnings - and they never mentioned it to shareholders even after it was an adopted part of their business practices. That's why the management's discussion and analysis exists in SEC filings. The message to managements: channel stuff if you like. But when you keep your shareholders in the dark about it, that's breaking the law.