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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.

As mentioned a couple weeks ago, one of the newer types of restatements we're seeing has to do with "floor plan financing" in the cash flow statement. Firms had been showing floor plan financing transactions lumped into the operating cash flows, when these third-party transactions are more accurately displayed in the financing section of the cash flow statement. A December speech by Joel Levine, the SEC's Associate Chief Accountant for the Division of Corporation Finance, at the AICPA SEC/PCAOB "current events conference" has raised awareness of the issue.

This morning, AutoNation filed a non-reliance 8-K indicating that they'll restate the 2004 and 2004 information in the cash flow statement in their 2005 annual report. Apparently, the restatement was prompted by a "customary review letter" (as they put it) sent by the SEC.

Hey, all review letters from the SEC aren't the end of the world. This one had a happy result for AutoNation, in that the restatement makes operating cash flow look better than it did before: for 2004, the revised cash flow from operations increased by $121.8 million; for 2003, it increased by $115.5 million. Maybe virtue is its own reward, after all.

Toss another log to the building bonfire of backtracking derivative shortcutters. Community Bancshares filed a non-reliance 8-K yesterday describing the restatement effects arising from its termination of the use of the "shortcut method" of testing for hedge effectiveness. (Refer here if you're new to the subject.) The restatement covers quarterly and year end 2004 results for 2004, plus the already-reported financials for the first three quarters of 2005. The revision's total impact will reduce earnings by $0.01 per basic share, for the nine months ended September, 30, 2005; $0.02 per basic share, for the full year of 2004. (No material impact on the 2003 financial statements.) To its credit, the firm "intends to hold this swap until its maturity date on June 8, 2007, [which will] completely offset the impact on 2004 and 2005 as the fair market value increases to zero up until its maturity date notwithstanding quarterly fluctuations. If the swap is held to maturity as is intended, there will be no overall effect on book value per share as a result of fluctuations in the swap's fair market value over its 3.5 year life." It's admirable because the company is choosing to go "fair value" with the hedge, and let the fluctuations hit earnings as they occur; they could just as easily go the hedge route by entering into new contracts to cover the hedged item and the derivative, with the proper effectiveness testing. There would be costs to do that, which would be borne by shareholders - and for what? As the company makes clear, there's no effect on equity over the life of the swap. Less admirable: the firm seems to be blaming the restatement on a shift in rules by the SEC, rather than as their own fault. To wit: "In light of recent interpretations of SFAS 133 within the industry and discussions between the Company's officers and its independent accountants in consultation with the Chairman of the Company's Audit Committee, the Company's officers reevaluated this transaction and determined on February 1, 2006 that the swap did not qualify for the short-cut method in prior periods." And they're not the only ones. Remember last week's restatement by Bank of America for their incorrect use of shortcut testing? Note this from the press release contained in the 8-K: "“The interpretations of how to apply SFAS 133, a quite complex standard, continue to evolve,” said Alvaro de Molina, Bank of America chief financial officer. “We monitor interpretations of accounting standards by regulators and accounting professionals as well as recent industry practices to evaluate our accounting practices. In light of recent interpretations, we reviewed our accounting treatment of certain hedge transactions and determined a restatement would assure that our financial statements adhere to the most recent guidance for accounting treatment of hedge transactions under SFAS 133.” ... An interpretation in the fourth quarter of 2005 addressed how companies should apply the “short cut” method for derivatives used as hedges under SFAS 133. Under the “short cut” method, if a company meets certain strict criteria, it permits the user to assume no ineffectiveness and then ongoing effectiveness testing is not required. If those criteria are not met in their entirety, companies must use the “long haul” method, which requires extensive documentation, analysis and testing at inception and during the life of the hedge." Let's check this out. There were no FASB Staff Interpretations issued by FASB in the fourth quarter related to shortcut effectiveness testing. There were no Staff Accounting Bulletins issued by the SEC that related to shortcut effectiveness testing. The only thing that happened in the fourth quarter was a speech by SEC practice fellow Mark Northan, in which he described the flaws that the SEC had been seeing in applying the shortcut method of effectiveness testing. Northan's comments did not constitute an interpretation; he was saying that the staff had noted that firms had failed the already-existing tests to qualify for shortcut accounting. For example: "... they failed to meet one or more of the criteria necessary to qualify for the shortcut method. The staff has therefore objected to the use of the shortcut method in these and other situations in which the specific criteria in Statement 133 were not met. In other words, the staff does not believe that the shortcut criteria have a "spirit" or a principle that can be met without strictly complying with the stated requirements..." Or: "... Companies have argued that the fair value must have been zero since no cash was paid or received when the swap was entered into. [Note: one of the undebatable requirements to qualify for shortcut testing is that the fair value of the derivative must be zero at the outset. Period.] The staff has rejected this argument because there were multiple components involved in the transaction with the financing element causing the swap to have a fair value other than zero at inception." One last comment by Northan dealt with error quantification. In other words, once the goof has been discovered, firms have to decide if it's material enough to warrant restatement. Firms have tried to quantify the mistaken accounting by comparing it to the accounting that should have been used, and the difference between that result and the wrong accounting drives how they approach the materiality decision. Sounds good, but it's wrong: recreating the long-haul effectiveness testing after the fact can make it easy to come up with a difference that might not be very material and not require restatement....

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Probably the most entertaining writer/economist/lawyer/actor I've ever encountered is Ben Stein. (And of course, the only writer/economist/lawyer/actor I've ever encountered.) About five years ago, I had the chance to see him in person at a conference sponsored by the CFA Institute (the Association for Investment Management & Research at the time) in Los Angeles. He's even funnier and sharper-witted in person than on paper, and he held the audience in the palm of his hand while he amused them with his investing tales. Unfortunately, they walked out of the room with him - and I was the next speaker, with my not-nearly-as-entertaining missives about pension accounting and stock option accounting.

Ben Stein is a tough act to follow, regardless. And I always enjoy his columns in the New York Times. I particularly enjoyed his piece yesterday about ExxonMobil; I only wish he'd written it when the oil-bashing was at its peak around the time that XOM had released their now-fabled earnings for the fourth quarter. Ben's point: who are critics angry with, when they're angry at oil companies for their profits? Are their executives vampirizing their employees, sucking away fruit of their labor for themselves? No. Should the ExxonMobil's critics be angry with the stockholder-owners? That would be self-hatred, because about "41 percent of the stock is owned by retirement funds, private, public (federal, state and local) and individual retirement accounts. In other words, by us." Should critics be angry at say, teachers, because one of Exxon Mobil's biggest holders is the giant College Retirement Equities Fund and they can now afford new golf clubs?

As Ben puts it, we can be angry at "them" all we want, but in the end, "them" is "us." It doesn't make sense to be outraged about Exxon Mobil's profits. (And before I forget - I do not hold any Exxon Mobil securities, do any work with them, or anything else. I just happen to agree with Ben.)

Remember the "Bizarro-Jerry" episode of Seinfeld where everything was inverted - Jerry had a beautiful girlfriend but was repulsed by her "man-hands", Kramer became a trusted executive in a firm when he was mistaken for someone else in the men's room, and Elaine had a trio of new friends who mirrored Jerry, Kramer and George - but were their polar opposites in temperament? It was a play on Seinfeld's fascination with Superman who sometimes visited a mirror-opposite Bizarro universe. (Don't ask me more about this; I was a Marvel Comics guy. What I know about Supe and Bizarro, I learned from Seinfeld.)

Anyway, from the looks of it - H&R Block has crossed over into the Bizarro universe, where up is down, back is forward, and black is white. As even a fourth-grade comics reader knows, Block is in the business of helping people with their taxes - yet in the Bizarro-universe, they can't get their own taxes right. Last June, they announced that they were restating their financials for 2003 and 2004, partly due to income tax accounting errors.

Yesterday, they filed another non-reliance 8-K, warning investors not to rely on financials for the fiscal years of 2004 and 2005, and the first two quarters of the current fiscal year. Reason: errors in determining the state effective income tax rate, resulting in a cumulative understatement of net state income tax liability totaling about $32 million at the end of 2005. The correction, on a cumulative basis, will be material to the January 31, 2006 financials.

Tax accounting, in and of itself, can be a pretty bizarre affair. H&R Block is proving that it can take even more bizarre turns. Superman, where are you now?

Critics of the Sarbanes-Oxley Act often charge that the legislation was hastily slapped together after the world-class accounting scandals of 2001 that left investors holding an empty bag. They complain that it was a political move that was meant to make legislative supporters look like they were doing something, anything, to the voters back home. Efficiency be damned! Financial reporting must be cleansed.

No complaint here about clean financial reporting; I'm one of those starry-eyed believers that capital will find its best home (as it should) when there's good information for investors to decide where they want to put their capital. And I'd find it hard to believe that every legislator understood completely every facet of the Sarbanes-Oxley Act as it wended through the halls of Congress; I don't doubt that some voted for it simply because they wanted to be on the side of the angels. (Right answer, wrong reason.)

But "hastily slapped together" is one thing that isn't true. Don't believe me? Check out Broc Romanek's nifty little history of Sarbox from his blog posting of February 23 at TheCorporateCounsel.net Blog. Its roots extend back to legislation proposed after the accounting scandals of the 1970's - Penn Central, Equity Funding, and others - and due to inertia or fateful quirks (death of a key Congressional backer; another backer retired) - nothing happened. Until 2001.

* * * * * * * * * * * * * * * *

While we're on the subject of auditing: Floyd Norris serves up an interesting piece in this morning's New York Times. I recall that back in 2000 - coincidentally, just one year before all hell broke loose - the SEC was trying to increase auditor independence by limiting the consulting services audit firms could perform for audit clients. One of the defenses raised by the audit firms was that by doing the consulting work, the audit firms could do a better job of auditing. Floyd offers an anecdote involving BDO Seidman and an audit client where this just didn't hold true. Check it out here.

About a month ago, I mentioned Tenet Health Care's restatement of financials from 2000 through 2004, based on a forensic review being carried out by Debevoise & Plimpton and Huron Consulting Group. Yesterday, they heaped another non-reliance warning on top of their previous "do not rely" admonition. Last time, it had to do with "under the hood" happenings that were quite invisible to investors; this time, it's along the same lines, but it has to do with taxes and stock option compensation. And it wouldn't be surprising if more of these emerge in the first quarter as companies get their stock option accounting polished up in anticipation of implementing Statement 123R.

Some of the Debevoise & Huron adjustments increased the net operating losses on the company's tax return. As a consequence, they also affected the amount of deferred tax assets on the financial statements, along with the valuation allowance. The charge for valuation allowance was allocated three ways: continuing operations, discontinued operations, and additional paid-in capital (due to excess tax deductions hanging over from earlier stock options awards.)

In closing 2005 and setting up for the implementation of 123R in 2006, Tenet's managers realized that the additional paid-in capital allocation was wrong and should have been part of the tax expense for continuing operations. They haven't yet determined the right allocation of the charge between continuing and discontinued operations.

What's curious about the restatement is that the catalyst for the tax adjustment was the implementation of Statement 123R. A while ago, it seemed like there was going to be a wave of restatements generated by the new standard's implementation; turned out to be just a brief ripple. Though you could argue that this one popped up because Tenet had control issues of its own, the "novelty" of Statement 123R still makes me wonder if there are more of these around the corner. (Even though its essence has been around for over 10 year, 123R is still novel if firms weren't applying 123 Classic in its strongest form.)

There's Bank of America's restatement for derivatives accounting done wrong. Then there's Lennox International's restatement.

Bank of America's restatement issue centered on the misuse of the shortcut method. Lennox, while forthcoming about the dollar effects of its flawed derivatives accounting, is restating for a different reason. Here's what it said in the press release accompanying the non-reliance 8-K:

"... In connection with the completion of year-end procedures related to the accounting for futures contracts for copper and aluminum, the company determined these futures contracts did not qualify for hedge accounting under Statement of Financial Accounting Standards No. 133 “Accounting for Derivative Instruments and Hedging Activities”, as the company's documentation did not fully comply with the requirements set forth in the standard."

Definitely not the same thing; no shortcuts here.

One of the biggest banks in America has become one of the biggest companies to restate its financials due to the improper use of the "shortcut method" of testing for hedge effectiveness in its use of derivatives. The bank monolith filed a non-reliance 8-K this morning which "neutralized" its financial statements for the first three quarters of 2005, and for the full year financials stretching all the way back to December 31, 2001.

Shortcut testing, you'll recall, allows a firm to skip the onerous proof of whether or not its hedges using derivative instruments have been effective for Statement 133 accounting purposes. The problem we've been seeing, at firms like CIT Group, General Electric, and recently, many smaller banks, is that the shortcut method was never really the right way to approach effectiveness testing for these firms. To get the shortcut treatment, there's a very black-and-white set of criteria to be met - otherwise the rigorous "long-haul" testing needs to be performed. Firms are now realizing, either with help from the SEC or their auditors, that they shouldn't have used the shortcut and need to restate.

That's what Bank of America is doing now. The numbers are pretty small: in 2005 diluted EPS, a reduction of $.10; in 2004, a reduction of $.05; in 2003, a reduction of $.02; in 2002, an increase of $.10. (No per share figures given for 2001, as it'll be a prior period adjustment in the restated financials to be published by March 16.)

There's been speculation as to whether or not the "shortcut failure" issue will become a restatement virus like last year's lease restatement issue. When the smaller banks suddenly began reporting restatements a few times a week, it certainly seemed like it would - then the restatements went cold. Does the BofA restatement mean that the virus is alive and spreading? The first reflex is that yes, they're back - but not necessarily. The smaller financial institutions that were announcing restatements in the last couple months of 2005 were likely to dope out the extent and consequences of dumping the shortcut method a lot more quickly than a giant like Bank of America. One guess: BofA has probably been working on these shortcut problems as soon as the issue surfaced, so they're remedied in time for the current 10-K filing. It could very well be that there are other giant financial services companies out there who needed the time to get this evaluation complete - and we could be seeing a spate of shortcut-related restatements coming from them. Still, there's no catalyst like last year's letter from the chief accountant of the SEC to the accounting profession that would spark a total frenzy like last year's lease restatements.

The Sunday New York Times piece, "A 'Holy Cow' Moment in Payland" by Gretchen Morgenson, perhaps previewed many such "Holy cow!" moments to come if the SEC's proposal on pay disclosures comes to pass.

As Ms. Morgenson put it, "in executive payland .. a holy-cow moment — [is] that electrifying instant when shareholders learn how much of their money is being siphoned off by their company's leaders." Perhaps "unholy cow" might be a more appropriate utterance. (Udderance? Sorry, couldn't resist...)

The object of the story is the disclosures made by Analog Devices in their proxy about the $145 million paid to chief executive Jerald Fishman. Holy cow!

Kudos to Analog Devices: they published their proxy along the lines of the proposed SEC disclosures, allowing shareholders to see more clearly what it cost the firm to attact and retain their managers - even if it is surprising. The figure is stunning in and of itself, and as you'd expect, it includes stock option gains. What's most interesting, though, is its disclosure about the above-market rates paid on deferred pay for execs and directors. As Itzhak Sharav, Columbia Business School adjunct accounting professor put it, "To the extent they pay them above-market interest, somebody has to pay for it, somebody suffers," he said. "And that is the stockholders."

Sure, these disclosures are better than what we're used to seeing, and there certainly is shock value to them. I have to wonder though, if they really facilitate any new analysis: there's going to be plenty of harping (as there always is) about the size of the pay package to the top execs and the performance of the company, etc. The disclosures will grease this kind of analysis, but do nothing to facilitate the analysis of how all recipients of such pay packages fared. Through the proxy process, shareholders are invited to approve compensation packages that extend widely into the bowels of a company - yet they're limited to reviewing the results of what they voted for through the prism of pay for just five executives. That's a shortcoming of the proposed disclosures - they don't cover all the persons covered by the plans that shareholders are asked to approve. Certainly, it would be too voluminous to list all the recipients in the same fashion as the top officers - but why not summary information on everyone in the pool? It would certainly provide useful feedback to investors about the costs of decisions they've made in the past.

Tiny Atari, Inc. filed a non-reliance 8-K yesterday due to an incorrect presentation in its cash flow statements for the past couple of years - 2004 and 2005, and the nine months ended December 31, 2006. Details of the amounts affected weren't disclosed; we'll see what the effects were when the firm files an amended 10-K and amended 10-Q.

What's being restated? The game company had taken promissory notes from a majority shareholder in satisfaction of a royalties due from the shareholder. According to the filing:

"In our previously issued financial statements, the amounts associated with these transactions had been reported as cash provided by operating activities and cash used in investing activities."

The statement above makes it sound like the cash in from the notes appeared in the operating section of the cash flow statement, while the lending actions appeared in the investing section.

Think of it as a cash flow statement arbitrage: the good stuff appears in operating activities, the bad stuff appears in the investing activities. You've carved up a single kind of activity into two components and put the good stuff where investors will notice (or at least take it for granted) and the bad stuff will be in a section where they'll ignore it (or at least expect it).

No picking on just Atari here: this cash flow arbitrage, whether intentional or just the result of sloppy thinking, has been at the heart of other restatements such as the floor plan financing issues mentioned a couple weeks ago. It's also at the heart of restatements last year by auto manufacturers and others with captive finance companies.

Anyway, the restated figures will put all of the notes activity in one bucket: the investment classification.

There's been increased SEC interest in the cash flow statement in the past few years, no doubt due to the fine work done by Professor Charles Mulford and his Financial Reporting & Analysis Lab. (Worth a visit, if you haven't yet.) That's not a bad thing, given that users pay attention to this statement more closely than ever.