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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.

There will be a lot of chuckling CFOs and controllers who hear about this...

The General Accountability Office performed its first audit of the Securities & Exchange Commission and released its report yesterday. Its findings: a clean opinion on the financial statements; an adverse opinion on internal controls. From the summary:

"...GAO identified inadequate controls over SEC's financial statement preparation process including a lack of sufficient documented policies and procedures, support, and quality assurance reviews, increasing the risk that SEC management will not have reasonable assurance that the balances presented in the financial statements and related disclosures are supported by SEC's underlying accounting records. In addition, GAO identified inadequate controls over SEC's disgorgements and civil penalties activities, increasing the risk that such activities will not be completely, accurately, and properly recorded and reported for management's use in its decision making.

GAO also found that SEC has not effectively implemented information system controls to protect the integrity, confidentiality, and availability of its financial and sensitive data, increasing the risk of unauthorized disclosure, modification, or loss of the data, possibly without detection. The risks created by these information security weaknesses are compounded because the SEC does not have a comprehensive monitoring program to identify unusual or suspicious access activities ..."


Rather ironic in view of the "material control weaknesses" that have been a steady drumbeat in the past year.

R&G Financial - a Puerto Rican bank, no relation to R.G. Associates, publisher of The Analyst's Accounting Observer - filed an amended non-reliance 8-K yesterday afternoon. Its filing was one of those things that you automatically might file mentally under "maybe this is one of the earlier ones."

In the process of securitizing financial assets like accounts receivable, mortgages and other loans, the selling institution will usually retain some portion of the securitization. These retained interests do not always trade in a market, and consequently, their value needs to be estimated for balance sheet presentation.

This is the source of R&G Financial's restatement tale. In April, the firm decided they needed to change the methodology used for valuing residual interests retained from our mortgage loan sale transactions. Their initial estimate of the rewrite: the retained residual interests as of December 31, 2004 could be cut between $55 million to $90 million after taxes ($90 million and $150 million before taxes, respectively).

Since their April announcement, the firm has worked on those estimates using their new, improved methodology; they now believe they must restate financials as far back as 2002. They've found other glitches in accounting for the deferral and recognition of mortgage origination fees and expenses, revenue recognition related to specific loan sales transactions, and the amortization process used in connection with mortgage servicing rights. And they've upped the high end of their estimate for the cut in value in the retained interests by another $10 million, to $160 million pretax. Total bill, to be sent to shareholders' equity: between $116 million to $134 million after taxes ($190 million and $220 million, pretax).


Is it automatically "one of the earlier ones?" Don't think so. Securitizations are chock full of interrelated moving parts: tug on one, you'll throw another out of kilter. We've seen a few other
securitization rewrites this year: at another Puerto Rican bank, Doral; at Fannie Mae; H&R Block; Countrywide; and Providian.

The common thread in these was pretty much simply that the companies erred on their own: there was no seismic shift in interest rates or systemic delinquencies that trashed all assumptions, all across the board. As I said, there are a lot of moving parts in securitizations - and that increases the probability of committing errors. Expect that there will always be a stream of restatements tied to securitizations - maybe sometimes it'll be just a trickle, and it doesn't necessarily prefigure a flood.


Interesting piece in this morning's NY Times by Gretchen Morgenson.

Analyst Tad Lafountain of Wells Fargo Securities has been put into the "penalty box" by Altera Corporation for his views on the company's use of stock options and share repurchases to offset dilution from them. Here's the drift, according to Gretchen:

Altera's main complaint about Mr. LaFountain's analysis relates to how he views the company's share buybacks... Altera uses such buybacks, as many companies do, to offset the share increases that result when stock options are issued to compensate executives and lower-level employees. In Mr. LaFountain's opinion, those repurchases are not in the shareholders' interests and are the equivalent of using stockholder money to buy shares at high prices and issue them to executives and employees at much lower prices.

For example, from 1999 to 2004, Altera issued 29.5 million shares through option grants at an average price of $6.94 a share. During the same period, Altera bought back 54 million shares at an average price of $23.97 each.

"When Altera has made over the last five years $2.44 a share and its tangible book value goes up only 61 cents, that means 75 percent of the earnings have disappeared," Mr. LaFountain said.


Just another example of why there's a need for a consistent application of accounting standards that take into account the cost of stock compensation. Statement 123R fits the bill. Let's hope companies will realize that behavior like this - or demanding the pull-out of stock compensation from earnings - is no way to build credibility. And that's something they'll want when they don't have it.

It's on the record.

At yesterday's Senate confirmation hearings, Representative Christopher Cox was asked about the FASB option expensing rule - a natural question, given that he's supported current legislation to kill it. This from the L.A. Times:

[H]e quickly defused one of the panel's main questions about him by saying he would support a new rule that requires companies to treat stock options as an expense. "The rule is going forward," Cox said of the measure he had previously opposed.

Sounds straightforward enough. Like I've said in previous posts, what you get in an SEC chairman is not always what you expected. Let's hope that Christopher Cox surprises us on the upside as some of his predecessors have done.

Good article this morning in the LA Times on SEC Chairman nominee Christopher Cox - pretty neutral, really, more or less a biography piece.

Cox's confirmation hearing is today, so we'll be hearing plenty more about his history - and projections about his future actions - once he's confirmed as chairman. As noted before in this space, he will be the most aggressively observed - and lobbied - chairman in SEC history. You've got special interest types like the U.S. Chamber of Commerce already calling for him to roll back regulations - especially any having to do with stock options. There are his California bonds with folks like David Dreier. And because of his ties to Silicon Valley through the law firm of Latham & Watkins, and his three-time record in proposing or sponsoring FASB-blocking legislation, he's also the subject of much trepidation, like this. Can't really blame Professor Ketz for feeling that way, either.

What are we going to get? I have no better idea than anyone else. I don't care for the man's legislative record one whit, but I have to admire his intellect and guts. I believe that when persons are put in the role that he's going to occupy, they can surprise onlookers with their fairness and their ability to put their past aside. And that's what I'm hoping for. He's innocent until proven guilty - and he's going to have plenty of chances to prove innocence or guilt.

Segment information has long been one of the areas that users of financial statements pretty much agree: more is always better. For the longest time, the segment information was something of a contradiction. Companies supplied the information in their annual reports according to a FASB prescription in Statement No. 14 - but in discussions with management, or in earnings conference calls, or reading the MD&A of SEC filings, investors found that the reported segment information didn't match up to the way managements were communicating their results.

A classic example: Sony Corporation. The company reported but two segments - Electronics and Entertainmnent - despite calls by its auditors and U.S.-based finance people for a split between "Music" and "Pictures" in the segments. You'd tend to believe they had managers of the motion picture business, but that wasn't the way things were reported to investors. In 1994, the firm's movie business was in sad shape and led to surprise asset writedowns, but the segment disclosures and MD&As prior to the writedowns, were never granular enough to give investors any clues. Eventually, the SEC slapped Sony with a "cease and desist" order.

Enter Statement No. 131, effective in 1998. Its aim: to have companies report segments to analysts and investors in the same fashion that they manage them. That way, reported results and management discussions are in synch. A beautiful thing, indeed.

From time to time, the SEC rattled its saber about the proper presentation of segments under Statement 131. And last week, it looks like Johnson Controls was on the receiving end of the saber: based on SEC staff inquiries, the firm filed a non-reliance 8-K on its financials filed for 2002 through 2004, and the quarterly filings through 2005. It will revise its segment disclosures for the Automotive Group. (Its Controls Group will remain unchanged.)

In 2004, the Automotive Group made up 77% of the 2004 revenues, 78% of assets, and 83% of total assets. Was it managed as just one unit? With a geographically diverse business like Johnson Controls', it would be tough to believe that. In the revisions to be presented, the Automotive Group will be shown as four segments: Seating & Interiors – North America, Seating & Interiors – Europe, Seating & Interiors – Asia, and the Battery Group.


From the sound of the titles of the new segments, those businesses must be the way they are managed internally - and thus, should be presented in the financial statements to investors. It will be interesting to see if there are any other restatements provoked by the SEC staff - or if this restatement initiates any self-examination by other firms.

Interesting survey, courtesy of Deloitte. I haven't read it; you have to request it from the firm, and you're free to do so if you wish. The press release alone contains enough interesting nuggets for me.

According to the release, Deloitte surveyed over 340 firms in technology, media, telecommunications, life sciences and other industries during 2Q05 - and came up with these conclusions:

- Companies are reducing the overall options given to employees. Lower-level employees will feel the effects more than the top dogs.

- Employee stock purchase plans (ESPPs) are being altered to avoid 123R compensation recognition, which will result in less benefit to the employees.

[Minute lesson: ESPPs allow employees to make purchases of stock at a fixed price - and that makes them options. Often the price is at a discount to the market, sometimes as mucha as 15%, guaranteeing a quick profit for the employees. Under non-123 accounting, such an ESPP does not result in compensation. Under 123R (and 123 Classic) if an ESPP is "broad-based" and has a discount less than 5% then it won't be considered a compensation plan. Cross the 5% threshold and you're in compensatory territory; you'll have to record expense for the value of the options.]


- 89% of the public companies in the survey said they're considering alternative equity-based compensation devices.

- 85% of the firms that hadn't adopted 123R said they wouldn't do so until they absolutely had to.

- Apparently firms may be becoming more sensitive to shareholder concerns about dilution: 74% of the surveyed firms said they intend to target potential dilution from options to 15% or less.

[Still not fair. Would you be happy if you bought a car and it got 15% less miles per gallon than advertised? Or had 15% less legroom? You get the idea.]


- Eight out of ten of the firms surveyed believe the move to expensing option compensation will have little effect on their stock price.

Only a survey, and not necessarily indicative of the universe, certainly. Judging from the sound of it, though, firms are getting over their phobia of recording stock-based compensation. The fact that they're taking steps to manage it provides support for an old maxim: you manage what you measure. When the primary "advantage" of stock options was that they didn't have to be accounted for, they were passed out with all the thoughtful consideration of an offer of chewing gum ("Gum?" "No thanks." "Options?" "Sure, I'll take a piece!") Not so when you have to measure them.

On the same subject: hats off to Microsoft, who, in their conference call yesterday, refused to supply analysts with stock-based compensation figures to back out of their earnings. In Mr. Softie's view, they consider stock-based compensation to be a true cost of business and expect analysts and investors to include such costs in their earnings modeling.

A far cry from the companies who are trying to have it both ways, and the toadying analysts who are trying only to stay in the good graces of those firms. Let's hope that analysts get over their fears, just as the Deloitte survey and the Microsoft example show that some firms are getting over their own fears.

It looks like Deloitte-the-global-firm isn't the only one of the Big 4 having trouble with wayward local affiliates. (Think Parmalat.)

This episode never turned up on my radar screen. KPMG International had a scrape with its Norwegian affiliate a few years ago. The affiliate had been responsible for auditing an outfit known as Finance Credit, which dealt in collecting distressed debt. Apparently, its principals hid the firm's own distress from the KPMG affiliate; in 2003, the firm eventually turned into "one of Norway's worst bankruptcies." It owed about $200 million. (Maybe that's why it didn't get a lot of attention here. Our then-current worst bankruptcies were a bit more dramatic.)

An Oslo district court has found that the Norwegian branch of KPMG is liable for the non-discovery of the fraud and ordered them to pay about $100 million.

Both episodes serve to illustrate an inherent contradiction in these global auditing business: they need to be global, but try to contain their own liability at the local level. From the sound of the article, KPMG was more successful than Deloitte has been in walling off its liability.

Just when you thought it was safe to lease again. Or account for leases, at least.

Continental Airlines filed an amended first quarter '05 10-Q and 2004 10-K because of incorrect operating lease accounting. This is the first airline I recall having lease accounting issues this year.

The problems centered on accounting for rent escalations and depreciation on leasehold improvements at airports and other facilities. The total lease expense adjustment for the proper accounting of rent escalations is $81 million, from 1993 through 2004; amounts range from $3 million to $12 million per year. The total depreciation expense adjustment is $30 million, for years between 1993 to 2004; adjustment amount run between $1 million to $6 million per year.

The correction added $2 million more of rent expense and depreciation to the 1Q05 net loss; no change in income taxes. For 1Q04, the restatement added $2 million more of additional rent expense and depreciation and a $29 million reduction of income tax benefit.

Don't hyperventilate yet, but there could be more of them. Once one player in an industry has uncovered an error like this, there's a burden on the others in the group - and their auditors - to consider the possibility that there could be a similar issue in their own house. The next couple weeks will be telling.

Cease and desist! Again!

Yesterday's posting mentioned the cease-and-desist order given to Comerica. Today's cease-and-desist: Foamex International, a much smaller fish in the sea. (Found in the depths of micro-capdom, in fact.) The firm manufactures - you guessed it - foam used in the manufacture of seating. One note of historical interest: for years it was headed by one Marshall Cogan, a former partner of Sandy Weill and Arthur Levitt in the days when they headed their own Wall Street firm: Cogan, Berlind, Weill & Levitt.

On July 11, the SEC slapped Foamex with a cease-and-desist order due to sloppy internal controls. This is not the case of some overarching Sarbanes-Oxley witch hunt, as you may have been conditioned to expect by now. No, this goes back to bad behavior existing before the Sarbanes-Oxley Act was even dreamed of.

What happened? Foamex violated the reporting, record-keeping and internal financial control provisions of federal securities laws. The SEC accepted Foamex's settlement offer, wherein they consented to the Commission's findings without admitting or denying them.

What did the SEC find? From at least 1999 through 2003, Foamex's auditors (mostly Deloitte) advised the firm of its significant internal control deficiencies, which could prevent it from presenting reliable financial statements. Deficiencies were found by the auditors in the areas of:

- information technology systems;

- inventory procedures, processes and systems; and

- preparation of quarterly financial reports.

Evidence that its systems weren't up to snuff: between 1999 and 2003, Foamex restated many of its interim financial reports because of material errors resulting, to some degree, from its its internal control issues. One example mentioned: Foamex had to restate financials for the first three quarters of 2003 due to an inventory overstatement.

Foamex's new management has attacked the problems, but the continuous warnings from the auditors showed that the company took its time in getting the problems under control. As part of the settlement, Foamex must "cease and desist" from its past behavior - and it also must adopt any "rehab" procedures specified by an internal control special consultant that it must hire.

At $1.3 billion in 2004 revenues and $646 million in total assets at year end 2004, Foamex falls into the category of "small issuer affected by Sarbanes-Oxley costs." It also illustrates why small issuers ought to be spending more on the kinds of controls addressed by Section 404. It would be ironic if the firms with the weakest internal controls are the ones that get the most relief from any revisions of Section 404.