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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.

The FASB and the IASB have been considering upgrades to their respective standards on business combination accounting for several years; they've finally linked arms and come up with a joint proposal to get their two standards in synch while patching up the holes in them. And it will take two standards to complete the upgrade.

Press release here. Exposure draft here. And here.

The Cisco proposition for valuing employee stock options has been mentioned a number of times in this space. (If you don't believe me, and you're the masochistic type, just type "Cisco" into the search box at right.) The story has gone pretty cold lately; we don't know if the SEC is going to buy off on it or reject it out of hand. And the reason is that there's an awful lot of evaluation of that proposition going on that is not seeing the light of day.

The Council of Institutional Investors, a voice for institutional shareholders, picked up its pen and outlined its concerns about that lack of sunshine in a letter to Don Nicolaisen, chief accountant of the SEC.

The CII letter mentions the issues that came to its attention from press reports, and requested "that the Commission, should it consider any formal or informal action, provide full transparency on this proposal and open a public comment period of at least 90 days to solicit the views of investors and other interested parties."

The Council's got its due process right - any consideration of this proposition deserves to be disinfected publicly. The real question, though: does this proposition, lobbed in the final seconds of the game as an obvious tactic to delay stock option expense treatment, deserve any serious consideration?

Another tidbit from the Financial Times: SEC Chairman nominee Christopher Cox is seeking a continuum at the SEC rather than revolution. And that means not upsetting the rules on stock option expense treatment.

According to the article:
"...people familiar with Mr Cox's thinking said he did not want to halt the FASB rules, which had been through careful deliberation. He also believed the body that wrote financial reporting standards should be free from political interference."

Strange stuff for a fellow who has sponsored three bills in his prior incarnation that imposed direct political interference on the FASB. The article was sourced from "people familiar with" Mr. Cox, and not direct statements from the man himself. Actions speak louder than words; we'll just have to see.

The Financial Times reports that on Monday, China's assistant finance minister said "China would "actively promote and accelerate" an effort to bring the country's rules in line with international accounting standards."

If the IASB goals of converging the world's standards into one unified body of accounting law are achieved, and China is on board, that would be pretty much the completion of the mission.

But don't hold your breath. The provincialism shown by European countries has been breath-taking and a huge impediment to the IASB's progress. Throw an 800-pound Chinese gorilla into the mix, and maybe you've got the makings of eternal gridlock.

As Sir David Tweedie, the IASB chairman pointed out: "They have particular problems in China that don't exist anywhere else ... "How do I deal with fair value when a share is traded in Shanghai and Hong Kong with prices that are one-third different? I don't know," he said. It was also unclear how Chinese companies would account for assets whose prices were determined by the state.

Yesterday's big news was the Scrushy/HealthSouth verdict. Dumbfounding. And it looks like dumb works in a trial, after all.

Fortune's Bethany McLean summed it up better than anyone so far in yesterday's "Street Life" column: "The lessons? Get a hometown jury. Give money—lots of money—to local causes. Get a website. Houston, we have a solution. (You can bet that Ken Lay and Jeff Skilling's lawyers are going to be all over this. And Lay already has a website.) The last lesson is that Sarbanes-Oxley—Scrushy was the first CEO to be charged under the 2002 law—is not a cure-all. But it's not all over for Scrushy, who still faces civil charges. Maybe the most relevant precedent will turn out to be O.J."

The 10-K filed the day before showed some pretty remarkable revisions to history. Looking further into the enormous filing, you can find a neat little summary in Note 2, regarding restatements. Consider these revisions:

- Acquisition accounting and related items. Overstated by $1,264,352,000.
- Existence and valuation of property and equipment. Overstated by $697,406,000.
- Additional asset and liability adjustments. Overstated by $611, 513,000.

There are plenty more, and the net total of all the adjustments was a downward revision to retained earnings at January 1, 2000 of $3 billion. Those adjustments turned retained earnings into an accumulated deficit of $2 billion.

These aren't minor amounts that were just spirited into the books by ill-intentioned bookkeepers. By now, you've read the same accounts of the trial as I have; it's hard to believe that a CEO could be so innocently blind to such gross overvaluations of assets if he's doing any kind of managing at all - yet that's what Richard Scrushy got the jury to believe. One thing for sure: no one will ever accuse him of being a micro-manager...

HealthSouth filed its amended 10-K for 2002 and 2003 yesterday. It was something of a two-for-one special: in addition to the restated 2002 and 2003 financials, it also contained a restatement of 2001 and 2000 financials. Still to come: 2004, and eventually, year to date information for 2005.

Some highlights:

- Cumulative net reduction to shareholders' equity of $3.9 billion as of December 31, 2001;

- Reduction in previously reported net income of $393.6 million for 2001 and $642.7 million for 2000.

- Writedowns of net goodwill and other intangible assets from $2.7 billion to $1.4 billion at December 31, 2001.

- Writedowns of property and equipment from $2.8 billion to $1.8 billion at December 31, 2001.

Those adjustments wiped out stockholders' equity; at the end of 2003, the stake of shareholders in HealthSouth was a negative $964 million.

By comparison, AIG restated earnings from 2000 through 2003 and knocked equity down by $2.26 billion at the end of 2004; it reduced 2004 earnings $1.32 billion, or 11.9%, from the previously announced $11.05 billion.

Neither company's announcements had much of an effect on their company's stock price - at least so far, in the case of HealthSouth. You could argue that the information in contained in the restatements was pretty much worked into the stock price for a long time. Or you could say that the investing world is becoming pretty much numb to multi-billion restatements.

A very good article on Friday in the New York Times, by Floyd Norris. Quote: "If you hide the facts on a different page of the financial statement, investors will ignore them."

What he's referring to is the concept of "comprehensive income," a statement that's been required in U.S. financials since before the turn of the century. (This century. In 1998, to be precise.) Here in the U.S., the statement is allowed to be presented in a number of different ways and locations in the financial statements, and it doesn't get a lot of attention from investors.

The IASB is proposing that such a statement be included on the income statement after "net income" - up front, where investors will see it and think about it, instead of buried in say, a statement of stockholders' equity. In fact, this approach was originally considered by the FASB when it developed Statement 130; if the IASB proposal goes through as planned, we might see such a presentation here in the United States as the two standard-setting bodies continue their efforts to converge the two sets of standards into one.

That's "if." According to the NYT article, the French and others in the European community are angered over the placement of such information. There could be the invocation of EU interference with this project just as there was with derivatives - and this time, it isn't even over new information. It's about where it's shown. Incredible.

Been a while since a Sarbanes-Oxley tidbit came this way...

This one will do. PricewaterhouseCoopers interviewed "CEOs of 341 privately-held product and service companies identified in the media as the fastest growing U.S. businesses over the last five years." (Go to www.cfodirect.com . You might have to register to get to the story link.)

Thirty percent of the private company CEOs said that the Sarbanes-Oxley Act has had or will have an impact on their businesses. Most of the "already affected" companies have been "improving their control documentation and testing, updating governance procedures, and strengthening their code of conduct or ethics." They view Sarbanes-Oxley compliance as a best practices issue, a way of preventing future problems rather than a cure for existing ones.

Only a third of those CEOs had invested considerable time in the process, and about half of the CEOs (in the 30% of the total group) were upbeat about the cost versus benefit equation: they expect a favorable payoff. The companies adopting Sarbanes-Oxley compliance policies tended to be the larger ones in the sample; they may have been concerned with their positioning because they expected to sell to another firm or go public.

Well, thirty percent is certainly not a majority of the survey. But - it's a surprisingly strong showing when you consider that private companies aren't even required to conform to the Act. It certainly runs counter to the typical press stories and to the posture of outfits like the U.S. Chamber of Commerce.

The SEC's off-balance sheet report, barely more than a week old, is already having some effect: the FASB is considering adding a pension accounting overhaul to their agenda.

In an interview with the New York Times, FASB chairman Robert Herz indicated that the staff would research issues regarding the sweep of such a project, and hopefully complete the fact-finding in time for the Board to vote "go-no go" on the project by early fall.

Plenty of room for improvement; there are so many artificial volatility-levelers in the current accounting that weeding them out wouldn't be hard, making this one a genuine simplification project. If the project goes ahead, it'll be interesting to see what remains of the old accounting devices. Just don't hold your breath, because it will not be a high-speed effort.

The lease accounting and pension accounting aspects of the report have gotten most of the press, because 1) the amounts at stake were so large and 2) the SEC made recommendations to the FASB to reconsider the accounting for these kinds of transactions.

Nevertheless, there's plenty of other interesting facts in the report. One aspect involved securitizations: that process of removing assets from the balance sheet in a sale to a special purpose entity - and often leaving a residual interest of some sort in the assets, one that's small relative to the assets sold but bearing a disproportional concentration of credit risk. From time to time, securitizations have generated as much Wall Street fear, loathing and just plain ignorance of facts as pensions or leases - so let's see what the SEC found out about them.

The numbers, as happens with securitizations, were pretty large - yet able to stay off of investors' radar. In their sample of 200 issuers, the SEC found that there was $790.9 billion of assets removed from the balance sheets. Without the transfers, total assets of the issuers (at $12.4 trillion) would have been about 6% higher. There were a net $10.3 billion of gains/losses recognized; and probably most intriguing, $161.1 billion of retained interests on the balance sheets.

What kind of retained interests? Interest-only strips, probably the most volatile of all manner of retained interests, clocked in at $5.6 billion. Servicing assets, those fees for managing the securities sold to the securitization trusts, totaled $22.7 billion, and "other" retained interests were $132.9 billion. The other category took in interests like overcollateralizations, bond interests, and seller's interests in credit card securitizations.

The remainder assets from securitizations paled along side the assets of the sample firms - but when you consider that they're more volatile assets than the ones they "replaced", comparing them to equity is a good idea - and they're over 7% of equity.

One gripe mentioned in the report: "It appears that some issuers exclude information regarding securitization transactions from their disclosures if they did not retain a subordinate interest, such as an interest-only strip, following the transactions. Further, the Staff notes that the sample issuers disclosed relatively little information regarding transactions with commercial paper conduits, such as transfers of trade receivables." If you've ever tried to dig into the guts of securitization disclosures, you know what they mean.

A curious aspect of securitizations: very often the retained interests aren't traded securities. They're estimated values, essentially "mark-to-model" amounts - one reason they can have volatile values, because they're sensitive to changes in assumptions. (Aside from the fact that their very structure can make them sensitive to the lightest of tremors in the bond market. See "interest-only strips.") That "mark-to-model" process is what opponents of Statement 123(R) have seized upon as so-called "unreliable, unworkable estimates of option value."

Wonder how many of them have "marked-to-model" retained interests on their balance sheets?