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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.

A couple of firecrackers on this last Friday before the Fourth of July weekend: Apple and CA Inc. both announced options dating investigations of their own. But that's a broad categorization: they're pretty different animals, both the companies and the options isssues. Apple's been the toast of the Silicon Valley set; on the other coast, CA Inc. has been the toast of the accounting restatement set. The differences in their option dating issues might be just as wide.

According to the press release and this Wall Street Journal article, Apple seems to be launching the now-standard special investigation under the direction of outside directors looking at irregularities in timing, and they mention one option grant in particular to Steve Jobs. The information is short on details, but sounds like the kind of heads-up seen so often before.

The CA investigation is unusual compared to what we've seen so far: some options may have been granted at one date, but employees didn't get notified until up to two years later. Can't recall anyone else having that problem, but it's a doozy in terms of size: maybe catch-up restatements in the hundreds of millions. The underlying mechanics are that you don't really have a complete grant to be measured until the grant has been communicated to the employees. A two year gap can leave room for quite a bit of appreciation in the value of the stock (and the intrinsic value of the options) from the time it was approved by the board and the time the employees found out, which is why there's such a dramatic catch-up. Until there's a fixed price for the options, a firm should be using variable plan accounting for the options, which is probably why the adjustments mentioned in the release seem so volatile. There should be an interesting backstory on this when all's said and done.

Yesterday the SEC settled enforcement proceedings against Raytheon Company and its former Chairman and CEO, Daniel P. Burnham, and Aldo R. Servello, the former Deputy CFO and Controller of the aircraft divisions, the Raytheon Aircraft Company (RAC). For the period between 1997 to 2001, Raytheon falsified the results of RAC; it masked the deteriorating conditions of the unit, and essentially made for fraudulent reporting.

Burnham and Servello agreed to the settlement without admitting or denying guilt. Others are still under investigation. For not admitting or denying guilt, it cost Burnham $1,238,344 and Servello, $34,628. Raytheon shareholders, who didn't admit or deny anything, will suffer a $12 million penalty.

What did Burnham and Servello do? Plenty:

"Bill and hold" revenue transactions. Between 1997 and 1999, Raytheon inflated revenues and operating income of the RAC by "pulling forward" sales of aircraft to fill in for operating shortfalls. Revenue was recognized on sales of incomplete aircraft, on which RAC had requested the "bill and hold" treatment (rather than the purchaser), with incentives given to the customers in order to tease them into accept a jazzed-up sale before the end of a quarter or year.

Without any disclosure of such terms in filings, Raytheon tapped public markets during this period.

Commuter aircraft business. The commuter aircraft business during the period in question saw a decline in profitability and a weakening position in the marketplace - which prompted a number of actions that included improper deferral of losses on leased aircraft, improper accounting for securitized loans, inappropriate use of reserves and pension income, and a lack of disclosure of all these items and their effect on earnings.

Cynically, perhaps, the company took a massive writedown for the division after the September 11, 2001 terrorist attacks - letting the general aviation industry problems caused by the attacks provide them with cover.

All told, Raytheon filed "at least fifteen quarterly reports, five annual reports, and four registration statements and prospectus supplements that contained materially false and misleading disclosures and financial statements."

Curiously, all these machinations took place during the internet bubble era - in a company that least resembles a dot-commer. It's a great example of just how many levers can be pushed in a company when you want to account creatively.

As I mentioned yesterday, I headed up to Norwalk to participate in FASB's discussion roundtable on its proposal for the first phase of overhauling the accounting for pensions and OPEB plans. What did I hear?

I was struck by a couple of things. First of all, it seemed virtually unanimous among the participants I observed (I attended only the afternoon session) that the FASB was on the right track in splitting the overall project into two phases: the fast-track Phase One which pulls netted information in the footnotes into clearer view on the balance sheet, and the long-track Phase Two, which will be a review of many knotty measurement and disclosure issues. The Phase One issue has no measurement issues in it; it's essentially a drag 'n drop exercise. (Drag the numbers out of the footnotes, and drop 'em in the balance sheet.)

Once everyone agreed on the two-phase approach, the roundtable members then spent about a third of the allotted time discussing Phase Two measurement issues and trying to keep Phase One from showing the projected benefit obligation as the measure of the firm's obligation for pensions. A two-track project is fine with everyone, it seemed - as long as it doesn't say much to users of financial statements.

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It was the last roundtable as a FASB member for Katherine Schipper, who returns to Duke University next month. Though she'll no longer be at the FASB, she'll still be "Katherine the Great." Duke wins, FASB loses.

Not much time for blog-posting today. Working up a new Accounting Observer piece, hopefully to be completed before vacation, and heading to FASB's Norwalk offices for the roundtable Phase One of change to the accounting for pensions and OPEBs. So, maybe it's fitting then, that the focus of today's posting is an interview of Thomas Linsmeier by Ron Fink and Marie Leone of CFO.com.

As I mentioned in a previous post, Tom is the newest member of the FASB. His comments on fair value reporting, derivatives, hedge accounting and complexity make for some interesting reading -a good encapsulation of some of the biggest issues FASB faces in the coming years. The whole interview is also a good primer on what ails the "mixed attribute" system of financial reporting. Enjoy.

We'll find out soon. This week, we'll see the launch of the first batch of ESOARS offered to the public. ESOARS stands for "Employee Stock Option Appreciation Rights Securities", and Zions Bank is the first firm to offer these strange new securities.

(Strangely named securities too - ESOARS? If they don't work out for investors, you can be sure the nickname will be "Eyesores." An even worse association: the childhood literary figure "Eeyore."

What are they? You probably noticed the article in the Wall Street Journal describing them as "another stab at 'public' options." It's not a bad description. They're essentially asset-backed securities that represent hoped-for cash payments from the exercise of employee stock options. That makes them all or nothing kind of securities: no exercise of options, no cash to be passed through to the security holders. So, the pricing of these things will be an exercise in option modeling. And they won't be traded in any secondary market after the offering, so the offering will be a pretty critical measure of the value of the securities.

That's because Zions hopes that it can use the price of these "reference securities" in its calculation of Statement 123(R) stock option compensation expense. Last year, Cisco Systems tried to build a very private market for a somewhat similar security, to be used for the same end. The SEC turned down Cisco's approach, and it had to stick with more traditional estimation of option fair values in calculating its 123(R) compensation expense. This time it's a more visible market, at least for the moment of the offering. Whether or not the values gleaned from that market are permitted to be used in the financial statements remains to be seen.

A story that's an echo of bubble years past: yesterday the SEC charged Scientific-Atlanta (now a unit of Cisco Systems) with aiding and abetting fraud at Adelphia Communications before that particular box of tinder exploded into flames. How did Scientific-Atlanta "aid and abet"?

Around August 2000, Adelphia asked Scientific-Atlanta to increase the price of digital cable television set-top boxes it was selling to Adelphia - then kick back the difference to Adelphia in as "marketing support" for moving the set-top boxes. Adelphia performed no such support, which is where the machinations get interesting: it capitalized the price increases paid to Scientific-Atlanta. When it received marketing support payments from Scientific-Atlanta, Adelphia treated them as a contra marketing expense, reducing its marketing expense - and increasing EBITDA.

(Those of you who believe EBITDA doesn't lie, take note.)

The SEC alleges that Scientific-Atlanta knew Adelphia was gaming the marketing support agreement while helping it along. Essentially, the charges were that the firm knew there was no substance to the transactions: they were designed to provide an unsupportable accounting appearance. Without admitting or denying guilt, Scientific-Atlanta is settling the charges for $20 million.

Interesting article on executive pension plans in this morning's Wall Street Journal by Ellen Schultz and Theo Francis.

The current investor outrage is about backdated stock options, making it easy to overlook the kinds of compensation quietly being accumulated in non-qualified pension plans. ("Non-qualified" meaning there's no tax benefit for prefunding the obligation, as would be in a "qualified" pension plan.)

Will the issues raised in the article resonate in quite the same way? After all, there's a commonality between the two issues in that the shareholders approve such plans, and then find out later the size of the check they signed. But it's doubtful that the executive pensions issue will resound the same way: there isn't the same element of the executives possessing better information about corporate prospects and translating that into a market advantage - or outright "shooting fish in a barrel" by selecting an option grant date that makes things work. Nope - this kind of benefit relates more to boring old compound interest, which doesn't generate nearly as much attention as stock market pseudo-wizardry.

About a month and a half ago, Altera Corporation announced a special committee that would investigate their past option grant practices. This morning, the company announced an update to to its investigation via a non-reliance 8-K filing.

The news is what you would expect by this time. The special committee did indeed find instances of option grants that didn't properly make it into the financials. They reached "a preliminary conclusion that the actual measurement dates for certain stock option grants issued between 1996 and 2000 differ from the recorded grant dates for such awards. As a result, the Company expects to record additional non-cash charges for stock-based compensation expense in prior periods. The Company believes that these charges are material and, accordingly, expects to restate its financial statements for the fiscal years ended 1996 through 2005."

That is one extensive restatement. 1996 through 2000 alone would be the restatement of the firm's financial history during the internet bubble era. That alone would provide some interesting contrasts between erroneous reporting and clean reporting. Ten years is really far-reaching, though. If it's material enough to affect all those years, you've got to believe that the grants issued in the 1996-2000 era had lingering effects in the subseqent years, even if the grants in 2001-2005 were properly accounted for. If so, it'll be a testimony to how mistakes in one period can affect reporting in many other later periods.

Altera's announcement focused on the "non-cash charge" aspect of the pending restatement; no amounts given in the filing. And no information was given on the sole cash aspect of the restatement, either: the firm didn't yet know if the findings driving their restatement would also affect tax deductions taken for the improperly recorded options. Hard to imagine that they wouldn't, but we'll see.

The calendar just turned to the lazy, hazy, crazy days of summer. And it feels like it here in Baltimore: our usual sultry summer weather arrived a bit earlier, complete with our special brand of humidity and smog that just hits you like a steamroller and leaves you feeling like you inhaled a dirty sponge.

Down the road in DC, they've been busy in the last few days leading up to the turn of the calendar page. Maybe they're trying to get things done before the infamous government vacation season goes into full swing. Here's a quick catch-up of some of the goings-on in DC that'll eventually affect accounting one way or another, whether investors realize it or not. Let's take 'em in descending hierarchical order, shall we?

At the top: a new boss at the PCAOB. William McDonough, the PCAOB's second chairman (don't forget William Webster) stepped down last fall. His replacement has finally been named: Mark Olson, former Federal Reserve Board governor. As you'd expect, he's got a lengthy banking background, including a stint as president of the American Bankers Association.

What will be interesting to watch: the FASB and the SEC are more interested in fair value accounting than ever. Exhibit one: we've got the FASB's "fair value option" project coming to fruition (possibly) by year end. No judgments here about Mr. Olson, but the banking industry has often opposed fair value accounting in most forms. Maybe there'll be some interesting tension as fair value reporting moves forward. And maybe not. But keep it in mind.

Moving down the hierarchy: founding member of the PCAOB Kayla Gillan has been reappointed to the Board - though I can't tell from the press release how long her term will be.

Waayyy down the hierarchy - yet near and dear to chairman Cox's heart: new guinea pigs for the XBRL experiment. Automatic Data Processing, Inc., Ford Motor Company, Ford Motor Credit Company, and Radyne Corporation all joined in. That brings the total up to 24 in the pilot program.

Great! Only about 14, 976 more registrants to go. I hope the wait will be worth it.

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Finally, a minor SEC story. Amusing, nonetheless.

Last December, the Commission issued a proposal that would make proxy materials available electronically. In (very) brief: investors would be advised that their proxy materials were waiting for them to be plucked off the internet. No more mailmen wearing trusses, no more pounds of paper in the recycling bin to go out in March and April for many households. Who wouldn't like the idea?

Not everyone, it seems. There have been some consumer protection concerns raised about the idea: not everyone might get the message that there's news waiting for them, and if there's something like a postcard being sent to notify shareholders, private information might at risk.

Who's the consumer advocate worrying about matters like these? None other than the U.S. Postal Service, who would definitely be the loser in this kind of reporting regime. Here's a link to their comment letter.

I wonder how much postal rates would increase if the proposal results in a major reduction of mailings.

Well, maybe "friendly" is pushing it. Slightly less hostile might be more like it.

Long-time critic of Sarbanes-Oxley Section 404 Paul Atkins delivered a speech to the French Association Of Corporate Governance last Thursday via satellite. French-fluent readers of this blog can find his remarks at the SEC website through this link. In French. For the rest of us bumpkins who ne savons pas parler en français, the English link is here.

(And if you're curious as to how well those "translate" websites work, Monsieur Google provides this link so you can compare. Vaguely amusing.)

Commissioner Atkins rarely misses an opportunity to bash the PCAOB's Auditing Standard No. 2, and he didn't give it a bye this time, either. But what was surprising was his near-admission of the importance of SOX as a whole, as expressed in this excerpt:

"... I am confident that the Sarbanes-Oxley Act can offer considerable benefits to shareholders. The emphasis on good controls over financial reporting is laudable. Section 404 focuses on the integrity of financial information and seeks to give shareholders additional insight into the credibility of financial statements... Our job — as regulators — is to ensure that the law's goal of improving the reliability of corporate financial reports is achieved in a rational and realistic manner, and that definitions of terms such as "material weaknesses" actually have meaning..."

If only he would have stopped there. But at least it was refreshing to hear the commissioner's general optimism about the future moderation of SOX 404 and auditing procedures instead of calling for their abolition. Unless it was lost in the translation.