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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.

Add Old National Bancorp to the growing list of failed 133 shortcutters.

This morning, the company filed its non-reliance 8-K for financials issued in 2004 and 2005. Its mistake: failure to recognize that the shortcut method of effectiveness testing for its use of brokered CDs in an interest rate swap requires that the swap have a fair value of zero at its outset.

Which in this case, it didn't.

An interesting non-reliance 8-K was filed this morning by Group 1 Automotive, one whose effects pertained mostly to the cash flow statement.

"Floor plan financing" is a common practice in the auto dealer business: simply put, it's the financing of auto inventory with a third-party lender, as opposed to being financed by the auto manufacturer through trade payables. Trade payables that finance a purchase of inventory would be included in the operating section of the cash flow statement. Transactions involving floor plan financing belong in the financing section of the cash flow statement.

Group 1 Automotive hadn't made the fine distinction between financings from its credit facility and its dealings with manufacturers in its balance sheet, and the lack of distinction carried through to the cash flow statement. In its filings, it revised the balance sheet classification of the two kinds of payables; in the revised cash flow statements, Group 1 pulled the floor plan financing effects out of the operating section and put them into the financing section. Result: cash from operations was lowered by $55 million for the year 2004; increased by $225 million for the year 2003; and lowered by $142 million in year 2002. Equal and opposite effects showed in the revisions to the financing cash flows.

Group 1 is the second auto retailer noted to make this kind of change in January. Last week, a similar reclassification exercise was executed by United Auto Group, with similar effects on operating cash flows.

What's driving the restatements? Probably a speech given by Joel Levine, the SEC's Associate Chief Accountant for the Division of Corporation Finance, at December's AICPA SEC/PCAOB confab. Levine set out the case that financings from sellers belong in operating cash flows, and financings from third parties belong in financing cash flows.

Does it seem likely to spread? Maybe. While floor plan financing arrangements are typical in the auto dealer business, there simply aren't a lot of them in the publicly-traded domain. The same cash flow statement reporting principles would apply to any firm that might employ floor plan financing, and they don't necessarily have to be in the auto business. Keep watching.

If your name is Evelyn Wood...

The SEC published its executive pay disclosure proposal on Friday. At 370 pages, it requires a forty-foot section of oak to be consumed for every printing.

Here's the link. Save a tree, read it onscreen.

Liability caps, those limits placed on auditors' responsibility to a company in the event of an audit disaster, have generated plenty of controversy since they first surfaced late in 2005. I was surprised by the mail reaction to a couple of postings I made here. (If you care to review, just see the new link at right, "Liability Caps.")

They'll be in the news again, I suspect. Not because of new revelations of widespread use of these auditing equivalents of prenuptial agreements - but because the Public Ccompany Accounting Oversight Board is taking up the issue with its Standing Advisory Group, indicating that the Board is giving it serious consideration and will likely weigh in on it eventually. The Standing Advisory Group will be meeting on February 9; the last thing they'll discuss that day is whether or not liability limits in audit engagement letters have an effect on auditor independence. Here's a link to the discussion background materials.

The PCAOB isn't the first regulator to take up the issue. Last June, the Federal Financial Institutions Examination Council came out strongly against practically any kind of limitation on auditor responsibility through engagement letters. Their hard-linecomment document is still a work in progress; no formal policy has been issued yet. When they do, it'll affect firms that report under the auspices of the Board of Governors of the Federal Reserve System (FRB), the Federal Deposit Insurance Corporation (FDIC), the National Credit Union Administration (NCUA), the Office of the Comptroller of the Currency (OCC), and the Office of Thrift Supervision (OTS).

While it's not a regulator, the Professional Ethics Executive Committee of the American Institute of CPAs also exposed a comment document regarding liability caps; in fact, they're debating the comments received on it this afternoon and deciding to issue a decision. As you can see from the PCAOB's backgrounder, they examined the same kinds of liability limitations as the FFIEC. With regard to many of the kinds of limitations, the two bodies were in surprising agreement. (For instance, both agreed that auditor indemnification against claims based on the audit client's negligence would not be a good thing for auditor independence.) In other areas, the AICPA was more favorably disposed to allowing limitations while the FFIEC was not. (Example: clauses that limited punitive damages were okay with the AICPA, but not the FFIEC.)

Another party has chipped in its two cents: the U.S. Chamber of Commerce. In the their position piece, "Auditing: A Profession At Risk," they argue for the creation of a system of alternative dispute resolution and criticize calls by the SEC and banking regulators (read as the FFIEC) for the toning down of liability caps as "misplaced regulatory overreach."

So - what's next?

The PCAOB, as mentioned, appears to be readying a response to the issue; you just don't put these kinds of things before the advisory group just to kill time. The FFIEC is readying their policy too - but hopefully, these two groups will see eye-to-eye on what kind of liability limitation is acceptable and develop similar policies. Otherwise, auditors of publicly-traded financial institutions will be subject to different constraints than auditors of publicly-traded nonfinancial institutions. A statement of the obvious: if limiting the prevalence of liability caps is a good idea for one kind of publicly-traded company, then why isn't it a good idea for all kinds of publicly-traded companies? Besides, whenever there's a difference in rules covering essentially the same kind of behavior, there's a possible arbitrage opportunity. It's not yet obvious what would develop here, but there's bound to be a clever lawyer who could figure a way to exploit the difference in the two sets of rules to create an unintended consequence.

As for the AICPA: their ruling would govern the auditors of nonpublic companies - some of which would come under the umbrella of FFIEC. So differences between the FFIEC rules and the AICPA rules could also create differences in engagement letters for financial institutions and nonfinancial institutions.

The question that comes to mind in all of this: is this trip necessary?

Or maybe: what's all of this worth to the auditors? None of the permutations of audit liability caps mentioned in the PCAOB backgrounder are going to absolve them of their liability to injured parties in the event of a colossal audit failure. In the auditing profession, appearances count - and with the liability cap issue, the profession is not making itself appear as strongly independent, even if the covered auditors are independent in fact. Liability caps won't help them cement credibility in the marketplace. If they are merely tinkerings at the edges of their responsbilities, is it worth looking seedy to the shareholders that hire them?

Groundhog Day approaches. I don't mean the actual calendar date, but the excellent 1993 Bill Murray movie about the Pittsburgh weatherman stuck with repeating the same day of his life over and over until he gets it right.

This Groundhog Day isn't nearly as funny or entertaining, I'm afraid. What's being done over and over is the filing of non-reliance 8-Ks with the SEC due to improper use of the shortcut method of testing hedge effectiveness. (Actually, the shortcut method is an alibi for not doing any effectiveness testing of a hedge transaction, so it's a bit of a misnomer.)

Today's company making us feel like we're stuck in Groundhog Day: The Banc Corporation of Birmingham, Alabama. Their 8-K filing denotes one of the prime reasons for a failed shortcut method: they didn't realize that broker's fees related to the CDs that are part of an interest rate swap have a fair value of something at the outset. And to get shortcut treatment, the fair value can only be zero.

Being in a link-happy mood today, here's a link to Michael Rapoport's piece on the subject in today's Wall Street Journal. And a link to Glass, Lewis & Co., whose analyst Jason Williams has prepared an excellent study on the subject and is cited in the article.

Last month, I mentioned that the SEC's Advisory Committee on Smaller Public Companies was meeting in mid-December and neglected to follow up on their recommendations to the Commission at the meeting. Their key recommendation is right here, and it can best be summarized as: create a protected class of public companies who don't have to follow the same rules as their larger counterparts, simply by virtue of their size.

Former SEC chairman Arthur Levitt opined on that recommendation in this morning's Wall Street Journal op-ed page, and I think he really nailed a few points worth emphasizing:

"The debate until now has centered on who should be exempted, not on how to ensure that companies have the internal controls needed to prepare reliable financial statements. This focus is unproductive since it is clear from a reading of SOX that Congress wanted all public companies to assess internal controls and have an outside auditor test them. Instead of defying Congress and provoking costly litigation, we need to work within the law to find ways to make compliance easier and less expensive for small businesses."

Internal controls are nothing new: Sarbanes-Oxley didn't invent the concept. The concept has been embedded in federal securities law since 1978 with the passage of the Foreign Corrupt Practices Act, and auditors were always supposed to have worked their evaluation of them into their examinations. SOX reiterated their importance, and they're important for all public companies. There's no small irony that much of the enforcement actions of the SEC relate to small companies - and they're the ones petitioning the SEC to be exempted from the internal control provisions. As Levitt accurately points out - the debate has centered on who should be exempt - not how to make the internal controls, and their assessments, work properly.

Levitt suggests that instead of scrapping over who's exempt, energies should be directed at fixing the problems encountered with Section 404 reviews in the first year:

The SEC and PCAOB should encourage accounting and financial executive trade groups and the software industry to develop tools that match the task of internal control evaluation for small companies and small accounting firms.
As Levitt puts it, adapting an approach developed for multinationals to a small business is "like diagnosing a cold with an MRI." In Year One of Section 404 reviews, there's no doubt that diagnosis occurred frequently.

The SEC should reconfigure itself to be able to be more responsive to small companies. Levitt suggests that some decentralization of the SEC's enforcement function could accomplish this.

The SEC and PCAOB should ease requirements - but increase enforcement. In short, give companies the benefit of the doubt when controls are found to be working correctly - but if they're not working right and restatements become necessary, expect a visit from your friendly neighborhood SEC examiner.

A good editorial, I think. See for yourself.

It's finally the time for Statement 123(R) to go into effect for all publicly-traded companies. Legislative efforts to derail the standard failed. So did efforts to minimize the value of stock options by creating a Potemkin village of a market for employee stock options, courtesy of Cisco Systems. And the SEC's recent proposals on executive pay disclosures require firms to include values of stock options based on Statement 123(R) accounting.

So you might think that the fight is over. Nope. Like a zombie in a George Romero film, this is the issue that won't stay dead.

What's happening now? Nothing overt, but the National Journal's Technology Daily (subscription required) reports a couple of interesting tidbits in a January 23 article written by Randy Barrett. To wit:

"Still up for debate is exactly how stock options should be counted. "There is considerably more work the SEC can do on valuation," said Jeff Peck, director of the International Stock Option Coalition.""

That might mean we'll see some old familiar arguments about the unfairness of valuing options in the comments on the executive compensation disclosure proposal.

Another tidbit in the article:

"Industry officials said they are waiting for the SEC to name a new chief accountant before the lobbying begins in earnest on the valuation issue. Donald Nicolaisen left that post in early November and his successor has not been announced."

If there's going to be "earnest lobbying", it'll certainly help the tech lobbyists to have a friendly face in the chief accountant's office. The selection of the chief accountant by Chairman Cox is going to be critical. It's bound to be his most highly scrutinized move to date.

Yesterday, the FASB issued an exposure draft entitled "The Fair Value Option for Financial Assets and Financial Liabilities" available for your downloading delight right here.

It's got nothing to do with employee stock options, folks, even though that's the only thing conjured up by the word "option" these days. What this proposal does is something pretty worthwhile, I think: if enacted, it will allow firms to report certain assets and liabilities at their fair value, instead of historical cost.

That's not a bad thing at all. A balance sheet tells its story about an entity's rights and obligations much more clearly when they're stated at what they're worth at the balance sheet date - not what they were worth three months, or one year, or three years ago. At the same time, it's true that what constitutes a "fair value" is going to have its problems too.

The proposal put some limits on what can be "fair valued" in the balance sheet. Barred from the option:

An investment that would be consolidated. (Like a subsidiary.)

Pension and other postretirement benefit plans.

Employee stock option and stock purchase plans, and deferred compensation arrangements

Lease liabilities

Written loan commitments not treated as derivatives

Financial liabilities for demand deposits

Maybe that sounds like a lot of exclusions, but there's still plenty of balance sheet territory where this could be applied. One possible upside to this proposal: if firms are allowed to apply fair value measurement to financial instruments they'd normally hedge, applying fair value to both hedged item and hedging instrument could create a "natural" hedging relationship in the balance sheet. That means there could less need for Statement 133 accounting, with all of its attendant headaches and opaque results.

The downside (apart from measurement difficulties): it's an option, not a requirement. That insures comparability problems between companies.