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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.

This note, from a friend in Boston, on my comment letter on FASB's proposal on cleaning up business combination accounting to make it report transaction fair values more effectively:

"Jack, I agree with your comments on bizcom with the exception of pre-deal costs. You say that these costs do not generate returns. I agree, but management better generate returns on them - I gave them the capital! If you bought a house for $100 and incurred transaction costs of $3 and then sold the house later on for $103, did you make $3 or $0 of profit? The other analogy often offered is that when I do an envirormental study for a steel mill (the cost of entry), that is capitalized - why is the buy vs build decision different?"

I think there are more benefits for investors in the proposed accounting than under current practice. A few reasons:

One, as I said, the payments to the bankers, accountants, lawyers, etc. only allow access to the assets. They do not generate the returns. If management is going to spend my money to employ these guys, I want to know how much and I want to know now so I can criticize while it's closer to the time when they're spending my money - when I have more of a chance to affect their decisions than if I have to wait a couple years for a goodwill writedown while they get paid plenty for managing my company. (And after a goodwill writedown, I still wouldn't know how much of any goodwill writedown really was related to transaction costs.)

Two, as I said, I sincerely believe these payments are of little future value, they are transaction costs. Putting sunshine on transaction costs has a way of making managers manage such costs. Putting it in current earnings makes them worry more about managing resources, I think, especially in context of making the numbers. Giving them a place to bury costs on the balance sheet encourages sloth.

Three, the FASB is serious about a fair value presentation of the balance sheet wherever possible. Excluding the transaction costs puts ONLY the fair value of the assets/liabilities on the balance sheet. Adding the transaction costs dilutes the meaning of the assets immediately.

In an income tax reporting model, I'd sure want to report the transaction costs as part of the basis in figuring a gain - unless I could deduct them earlier, before I sold the house. I can't do that for taxes, but I think it makes sense in GAAP. I admitted in my letter that this is at odds with other treatments - inventory , and securities being two examples - but I think that either of those methods do not accurately reflect fair values. Analogies are often helpful, but I don't think this is analogizing to a good model. Fair value is not something we're going to have to pick and choose - I think we have to be consistent in applying it. I'd hope the FASB looks at other "capped" costs down the road.

Last week, I mentioned that I'd penned my response to the FASB's proposal for a second phase in cleaning up business combination accounting. The proposed standard is likely to be somewhat controversial: not because it's a single mammoth change in practice, but because it cleans up many long-standing sloppy acquisition practices - and I mean sloppy in terms of solid accounting theory.

You don't expect everyone to like change - most of all, you don't expect the companies preparing financial statements to appreciate changes. You do expect that organizations formed of accountants to be a bit more supportive of advancements in their craft - but it's not looking that way in the European Union.

Accountancy Age, a British trade paper about - what else? - accounting, reports that the Institute of Chartered Accountants in England and Wales (the ICAEW) has slammed the FASB proposal. (The ICAEW is to chartered accountants in Great Britain what the American Institute of Certified Public Accountants is to CPAs here in the United States.) According to Accountancy Age:

"Last week internal market commissioner Charlie McCreevy warned that IASB that 'convergence is not an invitation to standard setters to try and advance the theoretical frontiers of accounting'.

'I will not take on board any revolutionary new standards,' added McCreevy. 'This should be a practical exercise, firmly anchored in business reality, to be undertaken in the interests of users and investors.'"

I hope Mr. McCreevy understands that business reality is what needs to be reported better to users of financial statements and investors. If a standard that is on the "theoretical frontiers of accounting" reports business reality better than "practical exercises," it should be welcomed rather than shunned.

Spent yesterday in New York; I had the chance to speak at the New York Society of Security Analysts' 12th Annual Financial Reporting Conference.

A good show for this kind of stuff, a really impressive cast of speakers, (pro forma-ing out myself there) and a surprisingly good crowd, given that it's earnings season. Always look for the backstory: it was less surprising when you realized that a lot of the audience was from the press. Still, it was good to meet up with some folks I've talked to for years and never met in person. (If you're reading this, you know who you are.)

A cold day in New York in the fall? Accounting? You call this work?

So, today's posting will be thin gruel indeed. There are two (long) Observer pieces that are begging for me to start, and I'm running in minimum-sleep mode. I'll be posting the talk I gave as part of a duo with Howard Schilit. Howard's done more than anybody I know to raise analyst awareness about accounting issues; our views on the question "has financial reporting improved?" weren't exactly symmetrical, but not exactly opposite either. Anyway, I'll put the script up next week on the Accounting Observer website. (Can't get it to the webmaster right now because I don't have the file with me.)

In the meantime, here's a link to my comments on FASB's business combinations exposure draft. Like I said, thin gruel. See you next week.

Same bug, different strain. They all relate to accounting, they relate to the SEC. It's the topics and the players that differ.

Almost a year ago, the SEC began investigations into pension and other postemployment benefit plan accounting at General Motors, Ford, Delphi, Boeing, Delphi, and Navistar. It wasn't any announcement by the SEC that clued in the public that such an investigation was going on: it was the disclosures by the players themselves in their public filings. There hasn't been a peep out of the SEC on the matter.

Another peep emerged from the disclosures of another filer: DaimlerChrysler. Mary Williams Walsh reported on Wednesday in the New York Times:

"...DaimlerChrysler disclosed that the Securities and Exchange Commission had served it with a subpoena in September seeking information in connection with a continuing investigation of General Motors' pension accounting. General Motors is one of six large companies whose pension accounting has been under review by the S.E.C. since October 2004. The others are Ford Motor, Delphi, Boeing, Navistar International and Northwest Airlines.

DaimlerChrysler said in a regulatory filing that the S.E.C. was seeking information related to methodology used in calculating pension and other retirement benefits for its North American employees. The S.E.C. said it also wanted to see "communications with G.M., Ford, and/or Delphi regarding such rate or methodology," according to the filing."

You can see the actual disclosures in the DaimlerChrysler 6-K, linked here.

It's still a puzzle. What did the SEC see in the investigations of the others that made a subpoena of DaimlerChrysler? Were these companies essentially passing around their homework to each other? And if so - was the homework correct? We'll just have to ponder it until either more clues seep out, or someone involved can actually talk about it.

One of my favorite parts of the day's end: getting Fortune magazine's Street Life in the e-mail. It's a daily wrap-up of market events, authored by a rotating cast of some of Fortune's most entertaining writers. And it lets me know what I missed during the day - like today. Says Andy Serwer in today's column:

"SAN JUAN SINKHOLE: Have you been following this Puerto Rican bank scandal? Me neither. Until now. Turns out the three biggest financial institutions there are under fire for bad accounting. Doral Financial, the island's biggest mortgage lender, just revealed that the SEC has begun a formal investigation. Stock is down to $8.80; it was close to $50 earlier this year. First BanCorp and R&G have also announced problems. Watch this space for takeovers! Hello? Chris Flowers speaking...."

Nope, not exactly following it: but back in April it was noted in this space that Doral Financial was making some pretty serious adjustments to its interest-only residuals resulting from securitizations of loans. And in July, it was noted that R&G Financial (absolutely, positively no relation to R.G. Associates, which is - me) was also having trouble making its accounting work when it comes to securitizations. As for First BanCorp, that one went by me. It is rather curious: three big players in a small area all coming down with the accounting flu.

Let's follow it now, at least for a little bit. First, a look at the First Bancorp announcement of the SEC investigation released last Friday:

One issue under review by the Audit Committee is whether the mortgage transactions at issue were properly classified for accounting purposes as purchases of the mortgage loans by First Bank or whether they should have been treated as loans by First Bank to the other financial institutions, secured by the mortgages. Although the Company's accounting analysis is not complete, First Bank has concluded that most of its transactions with one financial institution, R&G Mortgage Corp, did not qualify as true sales as a legal matter. Accordingly, these transactions may need to be accounted for as a secured loan to that financial institution. As a result, First BanCorp may be required to restate its previously issued financial statements for the period from 2000 through the first quarter of 2005.

Any reclassification of the transactions as secured loans rather than as purchases of mortgages would affect the notes to the Company's financial statements as well as the Company's presentation of its cash flow from investing activities. The Company is reviewing the adequacy of its allowance for loan losses relating to the potential reclassified secured loans as well as the regulatory capital implications of the reclassifications. Any need to change the allowance for loan losses would impact previously reported net income and loans net of allowance for loan losses.

Interesting: looks like R&G Financial and First Bancorp may have gotten the flu from each other. R&G Financial, in yesterday's disclosure about the SEC investigation, was much less forthcoming - and made no mention of First Bancorp or any other institutions. As for Doral, its release today was for the purpose of notifying investors that "it no longer expects to file by November 10, its amended annual report on Form 10-K for the year ended December 31, 2004. The delay is principally attributable to new information regarding the Company's mortgage loan sales to local financial institutions."

Note the plural: institutions. It'll be interesting to see if there other players yet to be named involved in this - and especially interesting if any others are non-publicly traded players.

When it became clear that reporting stock option compensation was inevitable, you knew this was going to happen: compensation charges tied to stock options would simply become a backed-out item in the neatly-spun pro forma earnings. What you would hope though, was that such inane "add-backs" of compensation expense wouldn't be expanded to include restricted stock charges. Managers know a good thing when they see it: the early indications are that they're going to add back all stock-based compensation charges.

EBITDA reporting, long a staple of pro forma reporting, is being expanded to exclude stock-based compensation by some firms. One example is microelectronics supplier Entegris, noting in their earnings release that EBITDA excludes stock-based compensation containing primarily restricted stock charges. One wonders: will the term EBITDASC (Earnings Before Interest, Taxes, Depreciation, Amortization, and Stock-based Comp) become part of the financial vernacular? That's doubtful: aside from sounding awful, it just draws attention to the fact that the figures exclude something to which management would rather just not draw attention. Namely, their pay.

Last week, the Wall Street Journal's Justin Lahart reported that Linear Technology was excluding all stock-based compensation from their pro forma earnings - including restricted stock charges. Their earnings release is probably a model of what to expect from companies: they don't overtly state they're pulling out restricted stock from GAAP earnings to get to pro forma earnings. Instead, they note that stock-based compensation under Statement 123(R) includes all forms of stock-based compensation including restricted stock, and then proceed to excise total stock-based compensation charges from earnings.

There are plenty of companies excluding stock-based compensation charges from their earnings in the current reporting season, which is the first one that will include earnings with Statement 123(R) compensation charges. (That's for companies with June 30 year ends.) Beware the generic "Statement 123(R) stock-based compensation" add-back because companies aren't being extremely descriptive about what's in it. You might assume that it's just options expense, but it might contain a healthy dollop of restricted stock comp, too - and for years, that never really bothered anybody. It's hard to recall instances of constantly-reported restricted stock add-backs. (If you can think of any examples, please drop me a line.)

So what? It's easy to dismiss such charges as a simple non-cash charge, but it's getting to the point where we're almost talking about earnings before costs. During the stock option accounting wars, restricted stock accounting was never contentious, even though it hit earnings. Now that both kinds of stock compensation currency are being recorded, they're all getting thrown out of earnings under the rubric of being "non-cash" - as if they were non-compensation, too.

They're not non-compensation - they're a factor of production in an economy driven by the brains and services of employees. You want cash flow, go to the cash flow statement. You want valuation on a cash flow basis, go to the cash flow statement for a start, and project cash flows yourself and discount them to a present value. You want to know what happened in a company, in totality of transactions for a given period of time, you look at earnings as a measure of performance.

Increasingly that performance includes restricted stock as a factor of production. For the S&P 500, restricted share grants increased 13% in 2004 - after increasing 74% in 2003 and 37% in 2002. That's not a trend likely to recede. It would be incredibly naive of investors to forgve companies for incurring compensation expense just because it's denominated in shares of stock, especially as it becomes a more material part of the corporate fabric.

As noted in this space on several occasions, the SEC has fashioned an advisory committee to study the costs and benefits of regulation under the Sarbane-Oxley Act. It met in Washington yesterday and again today "to discuss possible recommendations for inclusion in the Committee's final report to the Commission."

No discussion of the discussion that I could find on the SEC website - but there was reporting from Reuters. A couple of excerpts:

"James Connolly, president, IBA Capital Funding noted that Refco Inc.'s prospectus contained internal control warnings that did not stop bankers and investors who backed the initial public offering."

"We need to look at fundamental changes," said Alex Davern, chief financial of National Instruments Corp. "Tweaking around the edges will not achieve the goal."

Let's think about that first comment about Refco. There were "internal control warnings that did not stop bankers and investors." The Section 404 requirements resulted in a warning that was ignored by people who shouldn't have ignored them. Their ignorance of available information speaks more to their ineptitude as bankers and investors rather than indicating there's a problem with the requirement. This is a shameless deflection of blame from those who are responsible for their own actions onto that easy-to-hit target, Section 404.

It's like saying that General Motors could save a lot of money if it didn't put speedometers in its cars because drivers go over the speed limit. Why, it could solve all of their cost problems!

About that second one: "We need to look at fundamental changes." If Alex Davern's name sounds familiar, maybe it's because he was one of the architects of the AeA's white paper “Sarbanes-Oxley Section 404: The ‘Section' of Unintended Consequences and Its Impact on Small Business - A Grassroots Uproar.” The AeA, a high-tech trade association has not exactly been receptive to Sarbanes-Oxley. As the CFO of a nearly $2 billion market cap "small business", you have to wonder just what kind of "fundamental changes" Mr. Davern would like to see.

A quick reality check on some of the praises sung about the small businesses that are supposed to benefit from this committee's work, with the aid of S&P's Research Insight database. At the beginning of October there were 2,516 companies with a market capitalization of $75 million or less - an approximation of the small company threshhold being used by the SEC and this advisory committee. The interesting thing is this: if the Research Insight database is accurate - and I have no reason to believe otherwise - there are plenty of companies that don't have financial data for the years 1995 (743 of them), 1996 (658), and 1997 (601). The 1997 figures represent about 24% of all the companies.

What's interesting about that? If they aren't represented in the database, it's because they weren't required to publish financial data that far back when they went public. That means that quite a few of the companies that this advisory committee is valiantly championing went public during the late 1990's bubble era, when the markets were pretty non-discriminating and so were underwriting standards. It seems pretty ironic that the SEC is going to so much trouble to carve out a protected class with these firms.

So far, the meltdown of Refco has been taken in stride by the markets. That's a half-empty, half-full glass: half-empty, market participants are just plain apathetic and more absorbed with the earnings reporting season. Half-full, market participants are ignoring Refco's woes because the firm's problems are self-contained and limited to its shareholders and creditors.

Not to be congenitally pessimistic, but it's the half-full view that's troubling. Refco's unregulated Capital Markets unit is part of the firm's bankruptcy filing; it's that part of the firm that deals with hedge funds and institutional investors. According to The Wall Street Journal, that unit's bankruptcy filing showed assets and liabilities nearly equaling each other - but that's based on book values and not the fire-sale asset prices of assets the firm will encounter during its proceedings. Creditors are likely to scrap over a much-diminished pie.

It's not clear yet how much derivatives exposure firms may have to Refco or how much custom-tailored derivatives business was executed by the bankrupt Capital Markets group. There could yet be some ripples throughout the financial system. If publicly-traded companies were relying on Refco for performance on derivatives they've used for hedging purposes, there could be some "broken" hedges that need to be reported in the fourth quarter. Keep your fingers crossed - so far, no firms have disclosed such events. Another possibility: hedge funds could have derivatives transactions with Refco Capital Markets as counterparty, and again, non-performance by Refco could have a negative second-order effect on them.

There should never be a reason to panic -but that doesn't mean complacency is always warranted. The next few months might still reveal some Refco fallout in ways not yet contemplated by the market's big thinkers.

Yesterday I mentioned Unisys' heads-up to investors about a possible revaluation of its deferred tax assets (DTAs) - an accounting move that carries some implications about a management's expectations about future profitability.

Almost as if to illustrate what I was talking about , Eastman Kodak upped its valuation allowance on its deferred tax assets on the very same day Unisys warned about theirs. That resulted in a third quarter $900 million charge for the battered film and camera maker; it's essentially a management confirmation of what's widely expected about the firm's domestic outlook.

You shouldn't expect pinpointed revelations from keeping tabs on these announcements and writedowns - but they're important for forming a context or backdrop against which you can compare other management assertions. If a management is giving an optimistic outlook for 2006 and beyond, while cutting back on the value of its deferred tax assets because of implicit concerns about their realizability, that's a contradiction that needs to be explored.

It's early in earnings season, still, but there's one thing mentioned in Unisys' preliminary earnings release today that played with my mind. Not that it was subtle: let me present the headline, and you can try to pick it out:


The magic words are "requiring review of deferred tax asset." Unisys has now had four straight unprofitable quarters, and it's carrying a $1.6 billion deferred tax asset on its balance sheet - which is a monstrous 30% of its total assets. Unisys' managers took pains to remind investors that the third quarter results are preliminary: they may change by the time the firm files its 10-Q, as they continue to evaluate the realizability (read: likelihood of getting cash tax benefits) of the deferred tax assets.

Not to put them in the same boat as Delphi and Dana, but both of those firms, at one time or another, have given investors early warning about the realizability of deferred tax assets.

That's important for investors because Statement 109, the relevant GAAP standard for income tax accounting, requires managers to make a forward-looking estimate of how they expect taxable earnings to consume its reported deferred tax assets. So when a firm increases its valuation allowance for deferred taxes - in effect, writing them down - it's implicitly saying that the future doesn't look too bright. It means there isn't enough expected taxable income to use up tax deductions or tax credits bundled into the deferred tax assets before they vanish because of a pending expiration date. Over half of Unisys' deferred tax assets at December 31 (see Note 7 in the 10-K) had a statutory life beyond 2009, so the size of any valuation allowance might say something about the timing of Unisys' profit expectations for the next few years.

Having gone through the Section 404 wringer this year, managers ought to be paying serious attention to asset realizability. If they do , they might be sharpening their pencils when it comes to deferred tax asset valuation allowances. Throughout the third quarter reporting season, keep your radar primed to pick up any clues given by managers about revaluing a firm's tax assets. It might provide a good context for 2006 earnings expectations.