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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.

If that greeting isn't one you like, please feel free to insert your own - as long as it's in the spirit that this greeting is given. Which is to say, camaraderie, companionship, and cheerfulness. The Three C's: they're not bad all year long.

No post today, or for the next week, for that matter. Serious downtime needed here, as I'm sure it's needed by you, too. Big plans today: I'm going to get my CDs in order. They're here in the stacks of paper to be read or tossed.

And I'm going to read those things or toss them in the next week. Small pleasures, like those, have the most weight at this time of year, as far as I'm concerned.

Thanks for reading the AAO Weblog this past year. I hope you've enjoyed it, and I look forward to writing more for you in the new year.

Big honking front-page article on "tax gross-ups" in this morning's Wall Street Journal, by Mark Maremont. "Tax gross-ups" refers to the compensation practice of giving more dough to executives to make them whole after giving them a taxable raise or bonus. It's a great benefit to the employee, because it's the gift that keeps giving: the gross-up itself is taxable compensation, leading to more make-whole gross-up compensation and so on until the incremental gross-ups approach or reach zero.

I recommend it heartily; maybe even clip it and save it, because it might be one of those touchstone articles that you'll want to refer to in the coming months.

One thing in Maremont's story I found amusing: the gross-up practice took off in the 1980's as a reaction to the 20% special tax placed on "golden parachute" payments. If I'm not mistaken, it was then-celebrity CEO William Agee whose bungled attempt at taking over Martin Marietta earned him a ticket out of the executive suite at Bendix Corporation. His pay was considered outrageous at the time, and was part of the popular outcry that led Congress to pass tax legislation triggering the special tax anytime a fond farewell exceeded 3 times the regular compensation - which is why these things are always structured at 2.99 times compensation. Anyway, the point: this was a source of general indignation 25 years ago. The more things change, the more they stay the same.

I suspect that executive compensation and disclosure about executive compensation will be one of the noisier issues of 2006, for a couple of reasons. (Editorial note: "suspecting" is not the same as "predicting.") First of all, it's an evergreen issue. There's been emotional outrage over executive comp since capitalism began. It's an issue of fairness, which is a very subjective thing: one man's fair pay is another man's rip-off.
(Remember the J.P. Morgan maxim that he wouldn't lend to a firm where the top executive made more than 20 times what the average worker was paid? That was quite a while ago.)

And second, the disclosure is done so badly, it just looks like something illicit is going on in pay packages. That might change soon: the SEC is working on revamping executive disclosure rules for the first time in 13 years. Read these excerpts from Chairman Christopher Cox's speech at the Economic Club last week:

What we will propose is disclosure that permits a complete and accurate understanding of the compensation package. Any judgment or action taken on that information is up to boards of directors and investors, not us.

It is absurd to think that the owners of an enterprise should be denied full knowledge of how much they're paying their employees. The shareholders own the company, and the executives work for them. Think about it this way: Which of our nation's corporations issues signed, blank payroll checks for its employees to fill in the amount, learning only after the employee has cashed it just how much that check was for?

Not only will improved disclosure of company information be useful to shareholders, it will also help directors — by getting them better market information about executive compensation decisions in other companies. It will help make their judgments better informed, and less susceptible to challenge in expensive lawsuits that cost shareholders and companies alike.

... A proxy statement today may well contain all the required information, and yet still not tell anybody much of anything. Is it really disclosure if the investor has to sort it out and piece it together? Imagine the reaction from the press if I met their request for a transcript of every word in this speech by plunking down a dictionary. "There ya go. It's all in here somewhere." Technically, I'd have complied. In fact, I'd have provided nothing at all of value.

... If someone orders a steak, you don't give them a cow and a meat cleaver. Investors should get all the information they need — and they should get it in a form they can use.

He's got the right idea. But any change will likely be met with resistance. That's not so bad - but what will be toxic is the innovation that follows. Any rigid format for disclosures is bound to bring to life a slippery new compensation innovation that slides through the cracks of new SEC regulations. Let's hope that the Commission crafts something that will capture information about all the goodies.

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Maybe it's because it's the end of the year and tax time is approaching, but it's been a good week for compensation articles. I forgot to mention Gretchen Morgenson's man-bites-dog piece in the Sunday New York Times: "The Boss Actually Said This: Pay Me Less." I don't think you'll see too many similar stories for a while.

Accounting Today reports that 2005 revenues of second-tier (after the Big Four) accounting firm BDO International hit $3.3 billion - an increase of 13%. Not shabby at all; and, its US arm BDO Seidman saw revenues increase by 21%, reaching $440 million.

Sounds impressive, but keep things in perspective. Ernst & Young saw their revenues increase by 16% this year - to $16.9 billion. One Big Four firm is the equivalent - revenue-wise, anyway - of five BDO Internationals.

Or just look at the similarly King Kong-sized worldwide revenues reported by Deloitte Touche Tohmatsu, also reported by Accounting Today: $18.2 billion, up about 11%. It's good to be king, but being one of the Big Four isn't bad, either.

From friend Tim L., a statement from an unnamed CEO of an unnamed company:

"Because the accelerated options are significantly underwater, the accelerated vesting will avoid the unfair representation of the company's compensation costs that would arise from recognizing future accounting expenses that significantly exceed the current fair value of the associated stock options. Avoiding this stock option expense will better reflect the true economic realities of these stock options.

Do you suppose he is writing to the FASB urging the adoption of exercise date accounting that he clearly thinks is the fair representation?"

Umm... no. But I suspect we'll see a lot more of this brain-numbing double-speak starting in the first quarter of 2006, when the whole world reports earnings with all stock compensation included in them.

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Apologies in advance: postings are going to be slim this week. The holidays, yada, yada, yada, Accounting Observer piece, yada, yada, yada. And they'll be scarcer next week: I'm going to take five. I suspect that the rest of the world will too, so let's all come back fresher in 2006.

This morning's Wall Street Journal "Tracking The Numbers" column teed up some issues related to the FASB's first phase of overhauling the accounting for other postemployment benefits (OPEB) plans - and by default, the accounting for pension plans, too. It seems like a good time to review the project decisions reached by the Board at last week's meeting. So far:

Unrecognized gains and losses of all stripes will no longer be netted against the funded status of the plans. That includes gains/losses of an actuarial nature, as well as gains/losss related to market value of assets. Those deferrals will now be shown in a pocket of the stockholders' equity section called "accumulated other comprehensive income." (AOCI for short.) In addition, values of plan amendments, and prior service cost/benefits will also no longer be netted against fund balance: they'll also be recorded in the same stockholders' equity pocket.

That simple act of relocating the items is what will bring the full amount of the plans' funded status into view on corporate balance sheets. No measurement changes: just geography changes.

Transition obligations/benefits get the axe. When the accounting for benefit plans came into being, companies were allowed "transition adjustments" to be amortized into costs over time. No more: whatever remains of those transition obligations or benefits will be charged off. They don't even get the AOCI treatment.

No requirements about separate line items on the balance sheet. It's still early in the process. Maybe the FASB will change their mind and require better disclosure on the face of the balance sheet about the benefit obligations. Why go to the trouble of making sure the full amount of obligation is more sensibly stated if users don't know exactly where it all resides on the balance sheet?

Changing the geography of the deferrred items won't affect the composition of benefit costs. Charging off the transition items will have an effect on the benefit costs, but no likely impact: there just aren't many big balances of transition items around. What the relocation of the deferred items into AOCI will do, however, is for the most part put big pressure on stockholders' equity.

How much? If you're a subscriber to The Analyst's Accounting Observer, pull out your copy of Volume 14, No. 13, "Ugly OPEBs Of The S&P 500: Searching For Sense In The Figures," and you'll get a good idea of how this change would have played out based on 2004 OPEB numbers. For the pension impacts, grab Volume 14, No. 8, "Pension Puzzlement: Effects On S&P 500 Balance Sheets" and pay attention to the "pension neutral" figures presented throughout the report. They're a fair approximation of what this treatment would have meant at the end of 2004 for the pension plans. (If you're not a subscriber, please do not send requests for copies of the reports. While the AAO Weblog is free, The Analyst's Accounting Observer is not. Hey, it's the start of a new year soon. Why not get your research department to subscribe? Rates are here.)

Yesterday's post on the SEC's roll-back of filing deadlines for some companies prompted this note from Mark M., a former audit partner:

"Jack, I will once again look at a topic from the standpoint of the auditors. It may not be a big deal to a company to accelerate its filings by 15 or 30 days, but this is a huge deal to the auditors. Let's not forget the logistics of doing so much work in such a short period of time for so many companies. While an effort is made to do as much work as possible pre-yearend, there are limits to that approach.

Concern was expressed by many that prohibiting companies from suing their auditors pursuant to engagement letter provisions would impact the quality of audits (as per your earlier blog and comments related thereto). I don't think auditors want to admit it, but condensing the period in which to perform the yearend work cannot be a positive development for improving the quality of audits and potentially has a far bigger impact then that arising from engagement letter provisions."

I think you're missing the point I made, Mark. My complaint is not necessarily that companies take too long in publishing financial information. (Although I'd prefer faster to slower, as would any user; back when the rules were first being proposed, I thought it was fairer to just require 10-Q filing when earnings are released. That way, companies who thought it was important to rush the job to release earnings would have to be certain they had the job done right - or maybe just release earnings later. Didn't come to pass, anyway.) My gripe was that by listening to everyone who's lodging a complaint about the fairness of a rule, the SEC is bringing complexity to a process that used to be pretty straightforward. And reducing complexity is their new initiative.

Of course I realize this is a huge deal for auditors - one could only expect audit quality to be sturdier with a longer deadline. There's no way to minimize that this will affect auditors, and many more of them if the original timetable had stuck. As for whether or not longer deadlines would improve audit quality more than engagement contract provisions, there isn't even the possibility of such a trade-off. And I prefer not to speculate about what goes on in the mind of an auditor.

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From Bo A. , a few thoughts on stock comp, pro forma earnings, and the earnings clearinghouses:

"I finally got around to reading your stock comp fever survey results (by the way, I guess I was one of the unvalidated participants). I'm not surprised to see that 80% of the estimates on First Call, Zacks, et al. do not include options expense. There is no way that the sell-side will switch to including these costs without being forced to do so. Nearly every buy recommendation (still far out numbering sell ratings, I believe) will look less attractive when published earnings estimate reflect options expenses. I don't know what the public justification is for not including these expenses, but the private one has to be that valuations are going to look richer (and for some companies a lot richer) with these costs in the numbers. First Call and Zacks will work to keep everyone "in line" which will further delay the process of getting these expenses into the estimates. In fact, I know from personal experience that you do the numbers their way or they will drop your estimates from their database.

I see the situation changing when companies can use the lower earnings base from years past to their benefit i.e. they lower this year's earnings base by including options expenses which makes it easier to achieve a higher growth rate next year (all else being equal). I mean that companies will start using the reported figures rather than pro forma ex. options expenses in their "spin" of results when it works to their advantage.

To illustrate, options expense is $0.05 this year and EPS ex. options are supposed to be $0.35. Next year EPS are supposed to be $0.40 ex. options expense of $0.05. The growth rate would be 14.3%. If you include options expense in both years, the EPS growth rate goes to 16.7%. The company might not care as long as growth was this high, but if growth is slowing..."

I think Bo's got a good point here - I think that the firms would naturally come around to reporting all earnings with all costs when those costs aren't terribly material any more. Conventional wisdom has it that stock option usage is declining. But Bo has a better point I think, and that's that it might be advantageous to include the costs when the growth rate can be spun in the company's favor. We'll keep watching.

Back in 2001,under then-Chairman Harvey Pitt, the SEC embarked on a mission to make firms file their financial statements and current events 8-K filings on a greatly accelerated basis. The 90 days allowed for 10-Ks and 45 days allowed for 10-Qs had been in place since the early 1970's, long before cheap computing power and software speeded up the financial reporting process. In view of progress, it didn't seem unreasonable to ask companies to hurry up and get their annual report done in 60 days and quarterlies in 35, on a phased-in basis.

That was then, this is now. Plenty of water has gone over that dam: the evaporation of Enron and Arthur Andersen, the passing of the Sarbanes-Oxley Act and the first full season of Section 404 reviews for companies of any size. Companies have lobbied for relief as the phase-in timetable unfolded, and there were carve-outs for companies that weren't accelerated filers - meaning they were given clemency if their public float was less than $75 million. Last fall, in light of Section 404 demands, a year's breather was given to all companies.

The final phase of the shorter deadlines would have arrived in the upcoming reporting season. Last September, the SEC softened the deadlines once again, offering for comment a revised schedule and serving up another category of filers: "large accelerated filers." These are companies with over $700 million of public float. Instead of the filing dates being the same for all public companies, there are now different filing dates for non-accelerated filers (companies with less than $75 million in public float); accelerated filers (between $75 and $700 million in float); and large accelerated filers (over $700 million in float).

Yesterday, the Commission approved the new deadlines. Here's a rundown on what's effective in the upcoming season and beyond:

Large accelerated filers will be subject to a 60-day Form 10-K annual report deadline starting in fiscal years ending on or after Dec. 15, 2006, and to a 75-day deadline until then;

Large accelerated filers will be subject to a 40-day Form 10-Q quarterly report deadline;

The now-redefined accelerated filers will be subject to a 75-day Form 10-K annual report deadline; and

The now-redefined accelerated filers will be subject to a 40-day Form 10-Q quarterly report deadline.

Non-accelerated filers (the really little firms) will continue to file their annual reports on Form 10-K or 10-KSB (Small Business) under the original 90-day deadline and quarterly reports on Form 10-Q or 10-QSB under the original 45-day deadline. Also, Form 20-F or Form 40-F filing deadlines for private issuers will not change.

Last week, Chairman Cox gave a speech in which he encouraged the accounting profession to reduce the complexity that's crept into the financial reporting system. The proposal approved by the Commission yesterday were riding on rails built long before Cox came on board; if he's trying to mend a tempestuous Commission, derailing the proposals wouldn't serve him well. It's hard not to observe the contradiction, however: one day the SEC is grousing about complexity in financial reporting, then a week later, it adds more complexity by balkanizing something as simple as when a company is going to file its financial statements. Giving exceptions and exemptions whenever a group asks for them only adds complexity to the system. What the SEC should have done is look at its original idea for reducing the filing times and figured out why it isn't a good idea now (it still is), instead of layering in complexity by cutting small firms an exemption.

Being a publicly-traded firm used to carry with it a sort of swagger that the firm was good enough to meet tough reporting requirements. Creating an incubator for small firms isn't going to serve investors well - and once the journey down that path has begun, it'll be hard to stop.

It's official: the divorce is final.

Last week, it was reported that Delphi's shareholders were unhappy with Deloitte continuing as the auditor, in view of the consulting work that the firm had done for Delphi in past years.

Yesterday, Delphi filed an 8-K indicating that last Wednesday, it selected Ernst & Young as its new auditor.

On December 1, Ernst & Young Chairman & CEO James Turley delivered a thoughtful and thought-provoking speech to the U.S. Chamber of Commerce.

The tone of the speech was surprisingly conciliatory: it wasn't a blast at the costs of Section 404 compliance, a tack you might have expected in order to get on the right side of an audience like this one. Don't believe it? Try this snippet:

"Let me say this: for those of us in the public accounting profession, the events of the past few years have been humbling.

Certainly, the accounting profession, our firm included, has taken some shots from regulators and others over the last several years, and I'm here to tell you that we deserved some of those shots. I do feel somewhat fortunate, though, that my profession has faced some very tough times, and not only survived, but emerged better for the experience.

The times have taught us the dangers of being arrogant ... of not listening."

Mea culpas aside, Mr. Turley goes on to make an interesting comparison of the criticism of auditors before and after Sarbanes-Oxley, and why it's different now:

"... It wasn't long ago that public company auditors were being criticized for being too cozy with clients, for underpricing audit work to sell other services, or simply for not auditing enough.

Today, some critics say auditors are too distant from corporate management, overauditing, and that we're charging too much.

Perhaps the courtesy of consistent criticism is just too much to ask.

However, as we think about this inconsistent criticism, there is something important to bear in mind. The criticisms of yesterday—auditors being too easy—and those of today—auditors being too tough—come from different camps and different points of view.

The criticism that got us here—the criticism that demanded that auditors tighten up—came from investors. It was their outcry that brought about the near unanimous support of the Sarbanes-Oxley Act and the creation of the PCAOB.

Today's criticism—calling for auditors to lighten up—comes from some in the corporate community who are bristling at the new mandates, particularly the 404 internal control reporting requirements."

Mr. Turley nailed that one: there's certainly an inconsistency in the origin of the criticism. You don't hear investors complaining about SarbOx nearly as much as managers. He goes on to cite some statistics about the period after the passage of Sarbanes-Oxley - and they're very useful to consider when you hear overinflated hyperbole about dangerous costs imposed on business by a piece of legislation that essentially required firms to do what they were supposed to be doing all along. His list:

"Since the enactment of SOX in mid-2002, the stock markets are up. The Dow-Jones average has risen over 20 percent and is hitting near 11,000, the Nasdaq is up nearly 58 percent, and the S&P 500 hit new four year highs just last week.

Mergers and acquisitions are up. The value of U.S. M&A deals in 2004 was nearly double that in 2002.

Looking at IPOs, in 2004, there were 242 initial public offerings, including 150 on Nasdaq. By comparison, there were 100 or fewer IPOs in each of the three previous years. In 2005, IPOs are on pace to match or exceed 2004 totals.

New listings on the New York Stock Exchange rose 43 percent in 2004 over 2003, and through the first three quarters of 2005 have risen 6 percent over the same period in 2004.

At Nasdaq, new listings doubled from '03 to '04—from 134 to 260. And the upward march has continued in 2005, with 193 new listings through the end of the third quarter.

Market cap on the NYSE and NASDAQ climbed from $11.6 trillion at the end of 2002 to $17.4 trillion on June 30, 2005.

The loan market is improving. 2004 was the busiest year for loans since 2000, and the pace hasn't slowed in 2005.

Public company bankruptcies have dropped by two-thirds since 2001, to some of the lowest levels in history."

Of course, you can't directly attribute any of it to Sarbanes-Oxley - but in fairness, you have to wonder: if it's been as bad as its critics say it is, how could so many good things have happened?

Turley then proposed that there are three upcoming issues for the accounting profession:

Accounting standards - and the need for reduction of complexity in them.

A focus on the information investors receive - which is also a focus of the SEC.

The health and sustainability of the accounting profession.

It's the last one where Mr. Turley's speech was its weakest. He argued that all participants in the capital markets have a stake in the health and sustainability of the accoutning profession (they do) but argued that the Big Four firms face significant financial risk from litigation (they do). The irony is that the same firms argued for consolidation to bulk up and protect themselves from financial risk. Now that they're facing litigation for having dropped the ball after mergers, they're arguing that they should be treated as too big to fail, with consequences for everyone in the marketplace besides themselves.

It's a very good speech, nevertheless - worth a read to gain another perspective on the world of accounting and auditing.

On the heels of the CIT Group restatement announcement, another financial institution announces that it's tripped up on the shortcut accounting for hedge effectiveness on interest-rate swaps. This time it's First Bancorp filing a non-reliance 8-K. Periods to be covered by restatements: from January 1, 2001 to March 31, 2005.

First Bancorp's announcement was short on details; it did mention that the swaps involved up-front payments to the firm, which would preclude the shortcut method of accounting for hedge effectiveness. That seems to be an ever-recurring theme.

First Bancorp also announced another need for the restatement: its accounting for mortgage sales to two other institutions, as discussed in previous posts. As with the swaps, no details on the nature or effects of the forthcoming restatements.