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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 the options backdating scandal grows, so will the purses of the trial lawyers...

Came across this press release by Kahn Gauthier Swick, LLC, a New Orleans law firm who have created "the nation's first privately funded independent Options Pricing Investigations Division" and urging shareholders to ask them about their rights.

It's serious stuff, and by all means, shareholders ought to take action where possible. For some reason, though, seeing this press release made me think of the lawyers' industrialization of asbestos claims, with radio & TV ads and "cattle calls" at various work venues.

Yesterday the SEC announced the settlement of charges against Tribune Company, with the firm neither admitting or denying the charges but agreeing to "cease and desist" from such activities in the future.

What activities, you ask?

In 2002 and 2003, Tribune wanted to improve its circulation standing, to attract better-paying advertisers to two of its publications: Newsday and Hoy. Rather than improving circulation by providing content that readers wanted, Tribune made arrangements with news dealers and distribution agents to take papers that they would circulate for free, or not even circulate at all. They'd take back papers as well, but shift the returns into Saturdays, holidays and other days that didn't enter into the analysis of paid circulation by the Circulation Bureau - making their plumped circulation figures look even more valuable to advertisers.

Circulation figures were overstated in 2002 and 2003 for the two papers by 14% to 81%. The sales figures were genuine shams, and had the effect of misstating accounts payable and receivable, as well as revenue and expense figures. The company made misleading presentations to analysts and investors based on the trends presented by the bogus circulation, and ultimately cost the firm $90 million to settle advertisers's claims.

All things are connected, much more than suspected. Tribune ran afoul of the SEC in that the bogus circulation arrangements resulted in filing inaccurate financial statements with the Commission; the firms didn't meet the "accurate books and records" requirements. Whoever dreamed up the bright idea for boosting circulation and ad revenues probably didn't count on that.

It seems almost like years, but just about six months ago, the accounting buzz centered on "hedge accounting shortcut restatements." It seemed as if every financial institution, large or small, had taken liberty with a derivatives accounting shortcut for which they did not genuinely qualify.

Bank of America was one of those restaters, you may recall. They also had deftly blamed the standard's complexity and "recent interpretations" of the standard for their self-examination. (Note: there were no real new interpretations. Just an enforcement of existing ones.) BofA indicated they'd be examining their practices going back five years and perform a restatement if necessary.

Looks like they're finished, as indicated by this 8-K filing. The surprise: undoing the hedge treatment increased their 2001 earnings by 10.4%. Undoing the accounting treatment also aided 2002 earnings by 3.3%, and decreased earnings by 2.5%, 1.4%, and .5% in 2005, 2004, and 2003, respectively. There's a bit (admittedly, a small bit) of empirical evidence for you: is it really worth the cost and accounting bother to hedge transactions, just to preserve an earnings number or trend? Managements will tell you yes, because Wall Street demands it. You still have to wonder.

Last week, R. Corey Booth, Chief Information Officer and Director of the SEC's Office of Information Technology, delivered the keynote speech at the 13th Annual XBRL Conference in Madrid.

Worth a read: it's a pretty clear-headed assessment of where the movement is and where it should be going, with a few glimpses of what might be the first user-friendly applications. Booth suggested that XBRL "tagging" might first be evident to users in earnings releases, rather than in full-fledged financials.

He also mentioned the challenges of getting the program going: lack of demand from the user community, perhaps because there's no really compelling demo of what XBRL can do; a light turnout from the preparer community for the SEC's pilot program; and the lack of a critical mass of XBRL expertise.

And he also mentioned the slow penetration of technology to the mass market: for instance, color TV was invented in the 1940's, but didn't outsell black-and-white until 1972. The internet took thirty years to go from the Department of Defense to your desktop.

Note that this was the speech given at the 13th XBRL conference. Let's hope we don't have another seventeen years or so to go before XBRL really arrives.

It's been a while since we visited the restatement zoo...

Today's trip is brought to you by retailer Coldwater Creek, who filed a non-reliance 8-K yesterday covering last year's financials.

Coldwater Creek had co-marketed a credit card with an unnamed card issuer; it received an upfront fee from the issuer when a customer signed on for a card and activated. Coldwater had been accounting for the "marketing fee" in its entirety upon activation in 2005 - but it should have been deferring the fee and recognizing it as revenue over a longer stretch. (The 8-K didn't say what stretch.)

The restatement will slice $.06 from the 2005 earnings of $.32, making it a lucrative arrangement.

The 8-K didn't go into details about the nature of the accounting involved, but it sounds a lot like a SFAS 91 issue. That standard calls for "origination fees" tied to loans to be spread over the life of a loan rather than recognized up front. A "marketing fee" charged by Coldwater Creek for procuring a credit card customer - a borrower who's being extended credit by the card issuer - sounds much like an origination fee. So perhaps CC is now going to recognize the revenue over the average outstanding balance of the customers procured.

If SFAS 91 sounds familiar, it's because Fannie Mae had her problems with it, as announced yesterday. Do not jump to the conclusion that this is the beginning of a new restatement wave. Calling it a coincidence makes much more sense for now.

From the folks that brought you the options backdating panic, a couple of really good articles...

Yesterday's "Long & Short" by Jesse Eisinger is a dead-solid perfect summary of how "in two short decades, stock options have gone from being the solution to the problem." He didn't go into details citing one professor or another with a really slick way to sniff out the next backdating bottom drop-out. He did, however, nail the reason why this issue resonates so loudly - and will continue to do so with regulators and prosecutors:

"...as the stock prices of the companies involved in the backdating-scandal tumble, investors are realizing that widespread abuse of options grants were more than about earnings.

They told you about character."

Anyone whose been overly sanguine about options issuance (doesn't matter, it's a bean-counter issue; it's in the denominator; everyone else is doing it; management is worth what they're paid even if I don't know what the worth is, etc.) for the last ten years completely missed the point. When there's minimal visibility into what people do with their compensation - with the resources entrusted to them by shareholders - you're going to find out the nature of their character. And that's exactly what's happening now.

He also rightly pointed out that the post-Sarbox required reporting for officer stock transactions might help reduce opportunities for backdating. Even if the quicker reporting deadlines weren't in place, only a flint-hearted scoundrel would think about backdating these days. (Or only if they were just plain dumb.)

Different article in today's Journal by Gregory Zuckerman highlights the whirlwind witch hunt going on over backdated options. Everybody and their brother is coming up with their own hit list of who might be next on the receiving end of a subpoena. It reminds me a LOT of the Enron death thrash, when people kept calling here asking if I had a list of companies who were "using SPE's" - as if it were some kind of off-the-shelf deodorant.

A worthwhile point made by Zuckerman: with everyone out there pushing some kind of list of potential villains, there's no sure way to separate the good guys from the bad guys. You won't know who they really are until the informal inquiry/special committee/US attorney general subpoena has been announced.

I've made no list myself; I've outlined what concerned investors can do for themselves in a couple of these posts. (Screen on "Options Daze" in the search box.) But remember, folks: it's all circumstantial evidence. Keep that in mind before you churn an entire portfolio. Unfortunately, this is pretty reactive thinking. As Eisinger points out, all these things have to do with character - and all the evidence has been out there for years. And there's a certain fellow in Omaha who's been saying the same thing over the whole stretch.

Yesterday, the Fannie Mae report was issued by the Office of Federal Housing Enterprise Oversight.

At 348 pages, it's going to have to wait a while to be read. (Like I said in previous post - king-sized Accounting Observer piece is in the works.) A quick grasp of the accounting importance in the report can be found in the SEC lawsuit charging Fannie managers with fraudulent accounting:

"... the Commission alleged that Fannie Mae failed to comply with the accounting requirements of Statement of Accounting Standards (SFAS) 91, which requires companies to recognize loan fees, premiums and discounts as an adjustment over the life of the applicable loans. In the fourth quarter of 1998, by not recording the full adjustment required by SFAS 91, Fannie Mae understated its expenses and overstated its income by a pre-tax amount of $199 million. Management's decision to book an amount significantly less than the adjustment amount required by SFAS 91 resulted in the company not only exceeding Wall Street expectations, but also hitting the earnings per share target necessary to trigger maximum bonuses. In the periods that followed, Fannie Mae made other departures from SFAS 91, including the implementation of a SFAS 91 Policy in 2000. Fannie Mae's SFAS 91 Policy used a "precision threshold" to determine the SFAS 91 adjustment amount the company would record. There is no support for the use of a threshold in SFAS 91. Implementation of the Policy led to misstatements of SFAS 91 amortization in all periods from the fourth quarter of 2000 through the second quarter of 2004. The Commission alleges that, on at least one occasion, Fannie Mae booked income when it was within its own Policy threshold, with the effect of meeting its earnings targets.

The Commission's Complaint also alleges that Fannie Mae failed to comply with the accounting requirements of SFAS 133, which governs the accounting for derivative instruments and hedging activities. Fannie Mae disregarded the requirements of SFAS 133 and qualified transactions for certain hedge accounting treatment based on erroneous interpretations and an unjustified reliance on materiality. By failing to comply with the requirements of SFAS 133, the company failed to qualify for hedge accounting. This failure led to the company issuing materially false and misleading financial statements for the periods covering the first quarter of 2001 through the second quarter of 2004. The vast majority of the anticipated restatement of at least an $11 billion reduction of previously reported net income is a result of Fannie Mae's improper hedge accounting.”

There were other accounting transgressions mentioned in the suit, but these were the main issues.

You can bet that the SEC learned a lot about the "practical application" by registrants of SFAS 91 and SFAS 133 during the study of Fannie's accounting. Maybe it wouldn't be a bad idea to take a break from the options backdating thrash to see which companies in your portfolio include SFAS 91 and SFAS 133 as part of their critical accounting policies. It might become more critical in the months ahead.

The only accounting issue on most folks' radar is backdated options. It's a big world out there, and there's more than one way to improve financial reporting. The same people flailing wildly now for backdaters were probably the same ones thrashing around over underfunded benefit plans a few years ago...

Anyway. In the past, I've mentioned FASB's proposal for making benefit plan obligations more visible in corporate balance sheets, and the comments on the proposal are due in a week. You might want to check out the crop of responses received so far and write your own; mine's here. So far, the biggest corporate gripe seems to be the elimination of the three-month gap permitted between plan measurement and the balance sheet date.

Blogs will be a bit light for a while. I'm working on a king-sized Analyst's Accounting Observer report on benefit plans, including the effects of this proposal on the S&P 500. It's been a time sucker, hence, the light blogging. If you care to see the report when I'm done - and there will be a time when people are concerned with things like this, and not just option backdaters - I invite you to sign up for a trial subscription here. (Please, institutional investors only.)

is a strong offense.

While the FASB hasn't yet formally added a lease accounting project to its agenda, it will likely do so by the end of June. Remember, the Board received a prompt from the SEC in its white paper report in June 2005. Some folks take exception to tinkering with lease accounting, and they're mounting an offense before it's added to the FASB agenda.

The Equipment Leasing Association has issued a white paper that "examines the myths that critics assert as supporting evidence that something is wrong with the US lease accounting rules; the analysis also will explode these myths and provide a view of reality."

If you don't want to read the paper, you can pretty much pick up the flavor from the press release entitled "Misguided Criticism of Lease Accounting Standards Exposed by New Equipment Leasing Association White Paper."

I was surprised to find a quote in the paper from me, dating back to last year's corporate spasm of lease restatements; I said in USA Today "the misstatements do not appear to have been intentional and the financial effects only minimal. I think it was just a bad policy.”

I still do. But those remarks are a pretty narrow slice. I also think that lease accounting needs to be revisited. A financial reporting system that lets companies show a return in the income statement from invisible assets and invisible financing is not giving investors the whole, clear picture of the firm's rights and responsibilities.

You can quote me on that.