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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.

Newt Gingrich testified a couple days ago before the House Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises, offering his views on what it takes to keep America competitive. And he floated a very bad idea:

"6. Examine Stock Options. The Congress should revisit the decision by the Federal Accounting Standards Board (FASB) to require the expensing of employee stock options (ESOs) by firms that issue options to their employees. A way should be found for startups and small companies to revert to the older model of stock options..."

Note to Newt: it's the FINANCIAL Accounting Standards Board, not the FEDERAL Accounting Standards Board.

And there's no reason stock options accounting needs to revert to the way things used to be - when shareholders didn't see in the income statement what they were paying hired help. Which is where pay belongs.

We've heard endless kvetching about the Sarbanes-Oxley Act and its Section 404 requirements; seems like an eternity. So, when there's an enforcement action of an internal controls law, my ears perk up: hey, something else that might show why internal controls matter to investors.

The internal controls law, in this case, is not SOX 404. It's the Foreign Corrupt Practices Act of 1977, and the company involved is Oil States International. The story is not an indictment of a bunch of really scummy managers; it's actually a pretty good cautionary tale in the sense that a) when you're making friends in a foreign country, be careful, and b) if you've got internal controls in place to prevent and detect fraud, be sure they apply to the right people. And if they're telling you something, listen.

Oil States does business in Venezuela, and one of its subsidiaries had hired a consultant to "interface with employees of PDVSA" - the state-owned oil company. Said consultant was not employed to obtain business for the firm, but to genuinely facilitate normal daily operations. One of those duties was to write invoices.

The consultant was approached by three employees of PDVSA who proposed a kickback scheme, and he went along with it. While Oil States had an FCPA policy in place, they didn't extend it to consultants who worked for the firm - and they didn't do a background check on the fellow either. In the course of more than a year, the consultant and cohorts bilked the PDVSA for hundreds of thousands of dollars, returning the funds to the PDVSA employees. Oil States was effectively the conduit for taking money out of PDVSA through its invoicing system, leaving a trail in its books and records.

The scheme might have been detected earlier than it was, had the US subsidiary's VP of finance not been satisfied with a dust-off answer he received when he noticed the Venezuelan profit margins didn't make sense.

In the end, the scheme was found out, the company made the proper disclosures in its filings about the investigation, and it cooperated with the SEC in their investigation of the matter. Oil States remedied the weaknesses in its internal control system and received a cease-and-desist order from the SEC (basically an admonishment: "don't let this happen again.")

It's the old story: "ounce of prevention is worth a pound of cure." But it's true.

There will be many, many smirking controllers who download this report of the GAO.

It was sent from the GAO to Chairman Cox, and it's a followup of the GAO's examination of the SEC last year. In that examination, the GAO noted that the Commission had some inferior internal controls of its own (while overseeing the implementation of Section 404 reviews at many thousands of public firms).

According to the GAO, there's still room for improvement. Their latest recommendations include:

"1. Staff the Office of Financial Management with the collective knowledge, skills, and experience necessary to achieve effective implementation of internal control over the financial statement preparation and reporting process.

2. Finalize formal, written policies and procedures governing financial reporting processes and related internal control and quality assurance, including the basic documentation, audit trails, and crosswalks needed to support financial statement amounts, to facilitate management review of financial information.

3. Formalize and place into operation a senior management council or committee to oversee financial reporting activities; provide advice; and regularly review the agency's financial information, operations, and policies.

4. Determine cutoff dates for significant account balances that are both appropriate and practical to facilitate interim financial reporting and meeting year-end financial reporting deadlines.

5. Prepare interim footnote disclosures to facilitate meeting year-end financial reporting deadlines."

Nothing subtle about the irony here; these very same recommendations probably appeared in a few thousand or so letters delivered to managements by their auditors in 2005.

Yesterday, SEC Chairman Christopher Cox testified before the U.S. Senate Committee on Banking, Housing, and Urban Affairs. His speech homed in on the fact that most investors in the United States are no longer the upper income elite, but are member of the typical households where investment decisions are made at the kitchen table along with budget and spending decisions. He outlined a four-point initiative for his Commission to complete in order to serve these individual investors better. His plan:

1. Moving from boilerplate legalese to plain English in every document intended for retail consumption;

2. Moving from long, hard-to-read disclosure documents to easy-to-navigate Web pages that let investors click through to find what they want;

3. Reducing the complexity of accounting rules and regulations; and

4. Focusing our anti-fraud efforts on scams that target older Americans.

Of course 2) and 3) are most interesting to folks with interests like ours. There was precious little in Chairman Cox's remarks that was new, however; the comments on reducing forms and developing interactive data were a good compendium of what has already been discussed by Cox and other SEC officials in various forums. These remarks however, still did not include any timetable for progress or any mention of milestone events.

The same could be said for his remarks on reducing complexity of accounting rules. He mentioned the SEC's off-balance sheet financing study released last summer; we know that it will take years for the FASB to remedy the issues named in it. He also addressed the "codification project" which will bring all accounting principles under one roof - another multi-year (multi-decade?) project.

Yet there was one topic conspicuously absent from the Chairman's testimony, one key part in getting at least part 3 of his four-part machine humming: the selection of a chief accountant. The Commission has been operating without a permanent chief accountant for about six months. One has to wonder: is it that hard to find someone who wants the job?

One also wonders: is the selection going to take place after the decision on 404 exemptions is made by the Commission? This could be a complicating factor in finding a candidate: any prospectives who have been contacted might be waiting to see where this goes. It would have a pretty direct bearing on the nature of the chief accountant's role for the remainder of Cox's tenure. If the small cappers must follow the 404 rules, there's going to be "natural policing" of those registrants by their internal controls and the private sector - their auditors. If the small cappers get their exemptions, then the SEC - including the chief accountant's office - will probably find themselves dealing with more frequent accounting issues among small fry.

An especially gratifying e-mail, from the controller of a private company who would prefer not to be identified at all:

How come I agree with so many of your posts, especially the ones on SOX exemptions and the Small Company Advisory Board?

Based on our respective positions (preparer and analyst), aren't we supposed to be sworn enemies, on opposite sides of the hide and seek game?Oh, wait. I forgot. I am also an investor. Oh, wait again. I forgot, I also need to access capital in the markets, even if it is currently only plain vanilla bank debt. I guess I am foolishly still holding out for that mythical level playing field for all the smaller companies that I compete with for access to debt financing.

I think that an important story for everybody to remember is what Michael Armstrong did at AT&T, taking all those risks to try to match those wonderful results achieved by his insightful, innovative and brilliant competitors at WorldCom. And we know how well that turned out. Of course I realize that such things obviously could never happen at companies below $128M (or $787M as long as the companies themselves give us a blood oath promise that everything is under control, just do not look behind the curtain.)

I don't know. I hope that I do not have to turn in my membership in the Preparer's Club for thinking these thoughts.

Well, I'd like to think that you agree with me because I'm a reasonable guy with incredible powers of persuasion. But I don't believe that any more than you do.

I think we agree because, as you point out, we're all investors at some level or another - and out of our own self-interest, we're better off when we have consistent, reliable financial statements on which we can base our investing homework. The capital markets should be just that - markets - and not casinos where investors not only have to find companies that meet their investment criteria, but they also must pick the companies whose financials they find most believable.

Reliable financial statements, prepared with integrity, let investors get on with their work of investing - and in turn, create healthy markets where capital is allocated best in the broad economy. I sincerely hope you retain your membership in the Preparer's Club - and that you infect a few more of your fellow members.

From Greg R., regarding a post on FIN 47 a few weeks ago:

In your last entry, you state that "The total tab for these companies to adopt FIN 47/Statement 143 is pretty small: under half a billion for the 43 firms. It's not a bank-breaker. But, it is something for common shareholders to monitor going forward, as it represents a claim that should, by its very nature, grow with the passage of time - and crowd out shareholders claims, to some degree." I agree with your statement. However, I believe you are missing the big story. The items most companies are reporting as AROs only scratches the surface of what will ultimately come on to corporate balance sheets (check out the utility companies if you want to see where this is headed). FIN 47 applies to a MUCH larger range of environmental conditions with MUCH larger price tags (in the hundreds of billions of dollars). That is what investors should be worried about, not asbestos. Asbestos is essentially immaterial. What lies below the water line could cause many companies to be rendered insolvent when FIN 47 is fully implemented.

I think you may have focused a bit too much on the last part of the post, Greg. What was being covered was the fact that we found 43 instances of new, previously unrecorded Statement 143 liabilities as a result of firms being jabbed by FIN 47 - and that it was surprising how many of them were real estate or retail oriented and connected to asbestos. I wasn't trying to imply that FIN 47 was somehow asbestos-specific, and if anyone else got this idea - stop. Click back to the previous posts on FIN 47 and how it energizes Statement 143, and I think you'll see that we're on the same page as far as what Statement 143 is all about. (And keep in mind that Statement 143 is the real "gorilla standard" when it comes to asset retirement obligations, not FIN 47.)

Keep watching this space for more on FIN 47. I've talked about companies with new Statement 143 obligations as a result of FIN 47. We've got more to share with you soon about firms who've increased their existing asset retirement obligations because of FIN 47.

All the media attention is (justifiably) on the Skilling and Lay show unfolding in Houston. What did they know? (How much could you NOT know and still be an officer?) What did they intend? One man's earnings management is another man's ... plain old management. And so on.

One small player didn't make the news much in the past week, though. The SEC enjoined one David T. Leboe from practicing before the Commission - that means, working as an accountant in a publicly-traded company - for five years. After that, he can ask for, but not necessarily receive, the chance to do so once again.

What did Leboe do at Enron? As an accountant with Enron North America, he's been charged with:

improperly accelerating the recognition of revenue from the sale of a construction contract,

concealing undocumented side agreements from Enron's independent auditors and,

he actively sought to keep others from disclosing information to Enron's independent auditors about these side agreements.

Hard to believe nothing was going on there, Mr. Skilling.

A couple of good articles on CFO.com in the past week, both about the SEC Smaller Public Company Advisory Board recommendations.

I didn't listen to the public broadcast of the April 12 conference where the committee spelled out its recommendations, but apparently Helen Shaw of CFO.com must have paid attention. Seems that one of the Advisory Board members - Drew Connolly of the IBA Capital Association - was miffed that some of the opposition to their suggestions sounds like the same points that have been raised by Lynn Turner, former SEC chief accountant and current research director of Glass, Lewis & Co:

"...We do know and can factually point out that the former chief accountant of the SEC, who is quoted in virtually every newspaper article I've seen, is organizing this commentary and has requested some of this commentary," stated committee member James "Drew" Connolly, president of IBA Capital Funding, during the committee's final public conference call Wednesday. Connolly said commentaries opposing the committee's proposals were solicited by Turner and "is not a groundswell of individuals coming together in opposition." Connolly added: "We should be aware there is a relatively broad-based coordination in and among these attacks on our work. And I for one resent it.""

Right. And all of the support from small companies for the committee's recommendations is a conspiracy, too? It's a ridiculous charge: Turner has certainly been visible on the issue and has certainly done some of the best research on why exemptions are a bad idea - so it stands to reason that the solid facts uncovered by his group should be cited in comment letters rather than generalities. (I did so myself, in my own letter. And nobody from Glass Lewis asked me to take a particular stance.)

In another article, Marie Leone chronicled the apparent growing divide between auditors and smaller public companies evidenced by the comment letters. And she quotes a highly asinine statement by committee Chairman Herb Wander:

"...Amid the volleys of comment letters fired off by companies and auditors, letters from institutional investors were largely missing in action. Wander called this poor turnout "disappointing" and suggested that perhaps the lack of opinion was itself a message. He also posited that the committee may want to consider a letter from the National Venture Capital Assn., which agreed with the committee's key recommendation on exempting smaller companies, as a proxy for the opinion of all professional investors."

Come again? Consider the letter from the National Venture Capital Association - agreeing with the committee's recommendations on exemption, of course - as a proxy for the opinion of all professional investors?

How about this letter from the CFA Institute, which might serve even better as a proxy for the opinion of all professional investors:

"The Council strongly opposes the major thrust of the ACSPC's report, which is to provide most SEC registrants partial to full exemption from the requirements in Section 404 of the Sarbanes-Oxley Act of 2002. Furthermore, we find the Committee's primary (or first tier) recommendation to establish a scaled system to determine whether individual securities regulations should be scaled based on the company's size to be most troublesome. As investors, as well as investment professionals, we view any scaling system for securities regulation to be a “slippery slope” which will lead to less reliable, relevant and timely financial reporting and disclosures. Overall, we believe that if this recommendation is implemented there would most likely be a decline, and/or no improvement, in the quality of information available to investors of smaller public companies."

The NVCA letter is sympathetic to the views of the Committee; the CFA Institute letter is not. THe NVCA represents the views of venture capital investors; the CFA Institute represents the views of all sorts of capital market participants. Yet the chairman of the committee tries to position the NCVA letter as representing the views of all professional investors.

Hmm... sounds like a conspiracy to me.

You know, it was supposed to be the accountants who were going to kill stock options.

Now it looks like companies are going to kill them all by themselves. Yesterday's revelation of an internal investigation into the timing/possible backdating of grants at UnitedHealth Group led to a shocking proposal by CEO William McGuire: eliminate new grants of stock options as well as other forms of noncash perks. You can see his remarks in the 8-K here.

Today, Vitesse Semiconductor reports an investigation of its own, similar UnitedHealth's investigation of stock option grant timing. Which is similar to the one announced by Comverse Technologies on Monday. That one might require a restatement of financials as far back as six years. The time needed to complete its review and restatement could lead to the company's delisting from the Nasdaq.

Back in November, Mercury Interactive got the ball rolling on the investigations of option timing. Their CEO was quoted as saying he knew of about thirty other Silicon Valley companies being questioned by the SEC about their option granting practices. It looks like the investigations may have spurred firms in other regions and industries to take a look at their own practices. (Minnetonka, home of UnitedHealth, is a long way from Silicon Valley.)

The pending implementation of Statement 123R, combined with a stiffer internal control environment (courtesy of Section 404) may also be provoking companies to bring their option granting policies up to the level of a defensible practice. Note however, that these actions or influences do not require firms to abandon the practice of granting options.

Back in 2002, Coke fired the shot heard 'round the world when it announced that it would adopt a policy of treating stock option compensation as a recognized expense. I'm wondering if UnitedHealth is firing a similar shot if their board takes up McGuire's suggestion. Wouldn't it be interesting to see firms try to outdo each other in trying to distance themselves from using stock options? (One advantage: the accounting would certainly be easier for them to maintain. There'd be less of a need for documenting the estimates of option values and all of the underlying assumptions. All by itself, that benefit could be a driver in any firm's decision to abandon options.)

Here's a case that shows that incentives always leave open the possibility for bad behavior. Even though it would be a good thing for employees to stock- the old aligning of interests with shareholders theory - it will still backfire when the employee puts his own interests ahead of shareholders.

The SEC entered a settled final judgment against Brian Burr, former CFO of Dollar General Corporation, as detailed in this litigation release on April 12.He was the only litigating defendant against the Commission's actions against the firm and several employees for alleged accounting fraud. An excerpt from the release:

"...In its complaint the Commission alleged that, in 1999 and 2000, Dollar General's accounting staff determined that Dollar General should have recognized $13.4 million in import freight expenses in fiscal 1999. Rather than restating prior periods, as required by GAAP, or recognizing all the expense in fiscal year 1999, Burr participated in discussions of possible ways to account for the $13.4 million in freight expenses that did not entail recognizing all such expenses in fiscal year 1999... Burr knew that deferring the bulk of the expenses to fiscal year 2000 avoided the negative impact on already announced fiscal year 1999 earnings as well as year-end bonus payments to Dollar General employees, including Burr. The Commission's complaint alleges that, by deferring the freight expenses, Dollar General met certain targets, including an internal target for employee bonuses and analysts' expectations for the Company's earnings per share for fiscal year 1999. If Dollar General had recognized the freight expenses in 1999, it would have fallen short of the bonus target and analysts' expectations."

By leaking the freight "variance" into earnings slowly, Burr preserved the earnings trend and delivered what Wall Street wanted. Much effort for nothing, as it later turns out. If you have to litigate your actions and you're barred from serving as an officer of a public company for five years, it's pretty costly too. It also illustrates the difficulty of designing incentives - whether payable in stock options or cold cash - that can't be gamed when someone wants to game them. That's why internal controls matter - and auditors need to examine them.