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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.

Yesterday, Progress Software announced that its study of misdated options was not yet complete but far enough along to give some guidance on how bad things might be. The study began in June, about the same time that many companies were announcing regulatory investigations of one sort or another. Progress' conclusions to date:

"... the Company currently expects to record additional non-cash charges in the range of $20 million to $30 million for stock-based compensation over the period from December 1, 1995 to February 28, 2006. The Company has not yet determined the amount to be recorded in any specific period, nor has the Company determined the tax consequences that may result from these matters or whether any tax consequences will give rise to additional tax liabilities.

Earlier today, the Audit Committee, in consultation with management and after discussion with the Company's independent registered public accounting firm, concluded that the Company's financial statements, including the reports of the Company's independent registered public accounting firm thereon, and its earnings releases and similar communications for fiscal 1996 and subsequent periods should no longer be relied upon.

The errors affected the accounting treatment of the Company's regular broad-based stock option grants as well as grants that occurred outside the Company's normal option grant cycle, and were not limited to stock option grants to executive officers, whose options were generally granted on the same date and at the same price as options granted to other employees.

The Company expects that it will be unable to announce its financial results for the third quarter of fiscal 2006 or file its related Quarterly Report on Form 10-Q until a determination of the appropriate stock-based compensation expense has been made..."

Progress' statement is probably a microcosm of the larger universe of companies investigating backdating issues. To the outsider, a couple months may seem like long enough to wade through option transactions. But Progress is talking about going back over ten years to review option grants that were part of the regularly scheduled programs and some that were not regularly scheduled. And they covered all employees, not just the top dogs. You have to wonder if adequate documentation even exists.

Think of this: how quickly could you recover a mere bank statement from 1995?

No wonder then, that Progress and its ilk are threatened with delisting and pummelling from hedge funds. Much as we'd all like to see this wrapped up quickly, just getting the facts is going to take a while. And "taking a while" to get the facts is leading to other unpleasant, unforeseen consequences.

As mentioned before, the fourth quarter of 2006 may be the beginning of a new Ice Age for defined benefit pension plans. IBM may have gotten it started, but other firms have jumped on the bandwagon - Tenneco last week, DuPont yesterday.

Troll through EDGAR, and you can find a couple other freezes occurring in an otherwise sultry summer: outdoor equipment manufacturer Blount International, and uniform services provider G&K Services both moved to freeze benefits. Tire retreader Bandag is another one, along with AK Steel Holdings, insulation maker Lydall, Inc., and pen maker A.T. Cross.

What do they all have in common? Besides having pension plans that are turning chilly, they're all pretty small outfits - the largest market cap belongs to AK Steel, at about $1.4 billion. The rest are all comfortably under $1 billion. It's not an exhaustive sample, admittedly - but it is one of those things that strikes you pretty quickly from a casual examination of the data. And it makes sense that small companies should be among the first to freeze plans: they often complain that they face many handicaps because of their size, and it would be logical for them to take advantage of any reasonable cost-cutting exercise. (I can hear it now: "We froze our pension plans to offset the increased costs of Sarbanes-Oxley Section 404.")

It also makes sense that the small firm freezing activity is pretty much unnoticed by the press. When a company the size of DuPont freezes its plans, it's big news. When a company with a $400 million market cap freezes its pension plan, it's a space-filler on the back page. Yet you might wonder: will the small "freezing" firms will see a bigger improvement in their results than the bigger ones? Might be an interesting study in a year or so. Or sooner.

Defense contractor Herley Industries has a strange saga going on: the firm and its former chairman were indicted for fraud by the Defense Department in early June. Its auditors, BDO Seidman, unilaterally withdrew from their review and audit engagements because of scope limitations placed on them by the management in their review of the April 30 quarterly financials. And the NASDAQ has announced its intention to delist the company because of its lateness in filing those financials. For good measure, BDO Seidman is disassociating itself from the audit it performed in 2005 because it can "no longer rely on the representations of management provided to date."

It might be handy for Herley to have an audit committee stacked with financial experts. Yet they don't have even one, at least in accordance with the definition of "financial expert" as commonly applied to publicly traded companies these days. Go back to the audit committee report in the last proxy for Herley, and you'll see a couple of startling admissions:

"The members of the audit committee have substantial experience in assessing the performance of companies, gained as members of the Company's board of directors and audit committee, as well as by serving in various capacities in other companies or governmental agencies. As a result, they each have an understanding of financial statements. However, none of them keep current on all aspects of generally accepted accounting principles. Accordingly, the board of directors does not consider any of them to be a financial expert as that term is defined in applicable regulations. Nevertheless, the board of directors believes that they competently perform the functions required of them as members of the audit committee and, given their backgrounds, it would not be in the best interest of the Company to replace any of them with another person to qualify a member of the audit committee as a financial expert."

Well, there's a lot to be said for experience being the best teacher, and that "book-smart" isn't always so smart. But looking back at this mess with 20-20 hindsight, the words "not in the best interest of the Company to replace any of them with another person to qualify a member of the audit committee as a financial expert" seem sadly comical. There's a reason why a financial expert belongs on audit committees, and Herley has provided an excellent example.

Last Friday, the FASB announced that board member Ed Trott will be retiring two years earlier than his term allows. He'll be heading off into the sunset come June, 2007.

Ed held one of the "public accounting seats" on the board, hailing from KPMG before beginning with the FASB in 2002. He's been a strong proponent of FASB's fair value projects, and a friend to investors. Hopefully the Board will be as fortunate with his replacement.

There's an interesting article by Eric Dash about the Mercury Interactive board in the Sunday New York Times. Dash referred to a recent speech at Harvard by SEC Commissioner Roel Campos in which he declared, “If the facts permit, and I want to emphasize that all our enforcement cases are very fact-specific, it wouldn't surprise me to see charges brought against outside directors.” Campos' remarks have relevance the Mercury Interactive case because three of its directors have been notified that they may be sued by the SEC.

I'd missed the Campos speech when it was first posted to the SEC website around the middle of August. The title of his speech was "How to be an Effective Board Member" and he had two pointed suggestions for board members with regard to backdating: "(1) don't use "as of" dates unless you have carefully thought about the consequences and have explicit approval from legal counsel that it is acceptable to use an "as of" date; and (2) don't assign critical board functions to "committees of one." Not bad advice - but probably a little late for the directors who might be finding themselves in the SEC's crosshairs soon:

I bring all of these cases to your attention to demonstrate that the Commission is very cognizant of the unique role of directors. We look very carefully at what you do, bringing cases only in egregious situations where there has been a clear violation of a director's fiduciary duty to shareholders. But we do bring them. This alone should motivate you to do your job well, not just to do it. An effective director should not find himself the subject of an SEC inquiry.

While it's not a declaration of open season on directors, Campos' remarks intimate that there's been a lot of thought given to director culpability in these cases. If the dam ever bursts - that is, if the SEC ever finishes investigating and starts prosecuting many cases - maybe we shouldn't be surprised to see a director angle on developments as well as plenty of culpability at the finance and accounting department level.

Interesting article in CFO.com: seems that the American Bankers Association was curious as to whether or not backdating lightning could strike some of their constituents. So, they commissioned The Corporate Library to examine the option granting practices of these 12 banks: Bank of America Corporation, Bank of New York, Capital One Financial, Citigroup, Commerce Bancorp, Countrywide Financial, JPMorgan Chase, Northern Trust, State Street, SVB Financial, Wachovia, and Wells Fargo. You can pick up the full report of their findings here. (Note: $1,100 needed.)

And they found... not much. Apparently, the big banks are pretty clean when it comes to option backdating - based on their option grant practices (like setting them on specific dates instead of at whim), and TCL's study of the patterns of subsequent gains. That might give the ABA some relief and some public relations opportunities, but until the audit season is over, it might be wiser to reserve judgment about innocence or guilt about a particular company or sector.

One thing the study does bring to mind: the financial institutions really have been noticeably absent from the lists of companies under investigation. If financial institutions haven't engaged in backdating, as the study shows, it would make sense. That's because they aren't major stock option issuers in the first place - they use them relatively sparingly, and when it comes to awarding stock-based compensation, they lean towards the issuance of restricted stock. You'd expect option abuses where there are more chances for them to appear - that is, where options issuance heaviest. And as we've seen, the backdating problems have occurred most frequently in the tech sector, the traditional hotbed of option compensation.

The banks in the survey may be the biggest in the country, but there are thousands upon thousands more to be examined in the coming audit season. There's bound to be a few surprises when it's all over, but the ABA and The Corporate Library are probably on to something.

Auto parts manufacturer Tenneco announced yesterday that it is "freezing" its three defined benefit pension plans (including one supplemental plan for executive officers), effective January 1, 2007. By freezing the plans, employees will accrue no more benefits under the plans; their existing benefits are preserved but they earn no new future credits. This is a similar move to the IBM change announced in January, one that was expected to kick off many copycat moves. There have been a number of them, and probably the most notable was General Motors. It's not a bad idea, and there'll probably be many more in the near future. More on that later; back to the Tenneco freeze.

It's not all a one-way street: Tenneco will be replacing the benefits that the employees lose with increased benefits in their existing defined contribution plans. No telling from if the employees get shafted, though I'm sure that someone will always run the numbers on these plan benefit swaps to show that they will. And the companies will always run them to show that they don't. It's one of those numerical exercises where you're comparing a fixed amount (the defined benefit plan give-ups) against a variable amount (the defined contribution give-back), so your assumptions in figuring the amount to be received in the give-back are critical. And whoever's running the numbers will introduce their own biases.

That's not the point here; sorry to stray. The point is that this move, as we all know, takes the investment risk off the employer and puts it onto the employee. That's not terribly new at this point; I think it's safe to say that most U.S. employees have become familiar with their 401K plans over the last 25 years, and especially in the last five (since Enron made them more conscious of what can happen to their retirement savings). And we also know that defined benefit plans, by their nature, are volatile creatures. The accounting for benefit plans has many awkward devices that are designed to reduce that volatility, while introducing lots of non-economic information into the financials. As FASB enters Stage 2 of its pension overhaul project, some of those volatility-flatteners may be headed for extinction. In the meantime, the newly-signed Pension Protection Act of 2006 will increase the funding requirements for defined benefit plans - adding another dimension of discomfort for sponsors. Expect then, that the Big Freeze to become much more common in the last quarter of 2006 as companies prepare to comply with the FASB "Phase 1" plan for moving pension and OPEB obligations directly onto the balance sheet. (Sidenote: Tenneco also replaced a couple of health care plans with one lower-cost plan).

The saying goes, "you manage what you measure." Firms will be measuring pensions and other postemployment benefits much more precisely now that the amounts will become visible to investors - and taking steps to minimize growth in the obligations. Freezing defined benefit plans is one way to get there, and there's every reason to expect more of these actions in the months ahead. Maybe the fourth quarter of 2006 is going to be the start of a new Ice Age for defined benefit plans...

Late in 2005, many companies were restating their financials because they had improperly taken the "shortcut" justification for skipping effectiveness testing in their accounting for interest rate swaps. Some firms had failed to sufficiently document their intention and justification for using hedge accounting - an explicit requirement of Statement 133, which governs derivatives accounting. For a time, it seemed like there would be a tidal wave of restatements, like what was observed with operating lease accounting in early 2005.

The derivatives restatements trailed off early in 2006. One Johnny-come-lately showed up yesterday, however: First Data Corporation raised the non-reliance flag on its financials as of and for the years ended December 31, 2003 through December 31, 2005 and as of and for the quarters ended March 31, 2006 and June 30, 2006. Reason: "... the accounting treatment afforded certain derivative instruments relating to the Company's interest rate swaps associated with its official check business and foreign exchange forward contracts associated with its Western Union business. Consequently, the Company plans to restate its Annual Report on Form 10-K for the year ended December 31, 2005 and its Quarterly Reports on Form 10-Q for each of the quarters ended March 31, 2006 and June 30, 2006." Restatements are also in order for Western Union, too.

Put First Data into the derivative restater category of "insufficient documentation." And also into the category of "deep denial." In their 8-K, they state that "interpretations of how to apply Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities ("SFAS 133"), and how to adequately provide documentation for such instruments so as to qualify for hedge accounting are very complex and continue to evolve." Statement 133 is quite clear that such transactions need to be documented: in a document that's already overly-prescriptive and bloated to something in excess of 850 pages, it's hard to believe that more instructions are needed for sharp accounting and finance people on how to document a decision they've made.

First Data points out that there's "no effect on overall cash flows, Total Stockholders' Equity, Total Assets or Total Liabilities from this revised treatment" and that "On a cumulative basis subsequent to the adoption of SFAS 133 and through June 30, 2006, FDC's Consolidated Net Income would have been approximately $30 million higher than that reported. Consolidated Net Income subsequent to the adoption of SFAS 133 and through December 31, 2002 would have been approximately $300 million lower than that reported. Consolidated Net Income would have been higher than that reported in each of 2003, 2004 and 2005 by approximately $90 million, $30 million, and $130 million, respectively. In addition, Consolidated Net Income would have been higher than that reported for the quarters ended March 31, 2006 and June 30, 2006 by approximately $55 million and $25 million, respectively."

Those annual differences work out to understatements of net income of 8%, 2% and 6%, respectively in 2005, 2004, and 2003 - and an overstatement of 17% for the combined years of 2002 and 2001 . (First Data adopted Statement 133 at the beginning of 2001.) That makes it one of the more notable restatements related to this topic.

Paying homage to that goddess Volatility, "As expeditiously as possible following the filing of this form, the Company intends to redesignate the affected derivative instruments as hedges with revised documentation and to account for them as hedging instruments in accordance with SFAS 133 so as to remove this source of potential volatility in reported financial results going forward."

No mention of what the explicit cash costs will be for removing the source of potential volatility. Maybe shareholders would accept a little volatility if they knew what they were paying for it.

All told, this a pretty interesting derivatives rewrite - and not just because of its size and historical scope. Most of the rewrites observed in late 2005 and early 2006 involved financial institutions. In fact, quite a few were smallish banks. So First Data is an outlier in the industry sense. Second, First Data's internal control self-assessment in 2004 and 2005 was that everything was working as it should and their auditors agreed. The restatement contradicts that - but with the restatement, it's likely that the internal controls will be effective at year end 2006. Sort of ironic.

You know the nearer your destination, the more you're slip-slidin' away...

Not likely Paul Simon had non-accelerated filers' internal control reviews in mind when he penned "Slip-Slidin' Away," but it perfectly describes the regulatory/industry attitude towards them. Every time the deadline draws near, there's another extension granted to non-accelerated filers. Compliance with SOX 404 just keeps slip-slidin' away.

The latest slide down the slippery slope of non-compliance was on August 9, when the SEC released a proposal for slip-slidin' the compliance date for non-accelerated filers from fiscal years ending on or after July 15, 2007 until fiscal years ending on or after December 15, 2007.

The reason is to give more time to managements to digest the new guidance the SEC plans to issue on Section 404 requirements as well as the new COSO framework on internal control assessments.

If the compliance date actually sticks (don't hold your breath), then calendar-year non-accelerated filers will be issuing their first management reports on internal control at the end of 2007. Their big brothers have been issuing such reports since the end of 2004. Given the bureaucratic build-up caused by the pandering to the small company front - increasing the guidance from regulators, COSO building a "lite" framework - it's no surprise that the compliance date is extended once again. If you have those constructs in place, then compliance dates have to be adjusted to accommodate them; that's what keeps the slope slippery.

The proposal document asks: "Are the proposed extensions in the best interests of investors?" No. The document also mentions that "...Approximately 44% of the domestic companies filing periodic reports are non-accelerated filers, and an estimated 38% of the foreign private issuers subject to Exchange Act reporting are non-accelerated filers." All that the delay does is give the opponents of any internal control reporting more time to lobby for changes to Sarbanes-Oxley. If they can't accomplish that should this delay become effective, then expect another slip-slide sometime next summer.

Last Wednesday, Intuit announced that their special committee had reached the end of its examination of the firm's stock option accounting practices. Their examination covered the period from Aug. 1, 1997 to the present. Their conclusion: the coast is clear. No issues found. No restatement required.

The stock advanced $.42, or 1.4%, that day, and retreated a bit since then. That was far better than the S&P 500's advance of .8% on the same day, and the Nasdaq's comparatively tepid .4% advance.

That says a lot about the market's relief at good news over backdating innocence. No aspersions cast here on the Intuit special committee - but while they "reported this conclusion to the Securities and Exchange Commission and the United States Attorney for the Northern District of California and will cooperate with any further inquiries," their 8-K and press release didn't indicate that the U.S. Attorney hasn't concluded their investigation. When that one is done, then maybe the markets should really breathe easier.

Which brings me to another point: there's been a lot of conjecture about the rate at which these investigations should take place. Intuit's was pretty quick: they announced it on June 29, and they're finished a month and a half later. Pretty quick compared to some of the stretched-out filings we're seeing due to backdating investigations. Here are some things to keep in mind when it comes to the length of time it's going to take to complete them. They may sound obvious, but a lot of people haven't been giving much thought to them.

The farther back the investigations go, the more difficult it will be to evaluate the situation. The farther back the problems, the more data there will be to evaluate, and the longer it will take to get that 10-Q or 10-K filed. There's simply a larger universe to be evaluated in an examination that goes back to 1995 than one that reaches back to only 1999.

There's more than just the option grants of the top five executives at stake. Sure, that's what makes the headlines; options are an important part of executive compensation, and a lot of investors (and journalists) are severely honked off about executive pay right now. But the option plans often extend deep into the bowels of a company; that was always one of the "Unique Selling Propositions" about option plans. Giving the options on 100 shares to each member of the headquarters cleaning crew would "empower" them and make them have a stake in the outcome of the company's future. When the time comes to clean up the accounting for the options, however, it's much more of a headache to do your fact-checking on 10,000 employees as opposed to just five officers.

As noted in the press, many of the investigations involve tech companies. There's no revelation there; we all know that's where the option action was. One particular trait of the tech companies: they really did believe in pushing the options out to all employees, not just the top dogs. You can find cases where the top dogs got a majority of grants, but for the most part, they gave them out more broadly than in other industries. As noted above, that leads to more backtracking work.

The systems and documentation in place during the periods in question were not likely "the gold standard." Remember that a lot of the transacations being investigated are in the pre-SOX 404 era: we know from the restatements and all the angst over getting internal controls whipped into shape that firms were not paying much attention to system details before then. Furthermore, since companies didn't expect to report stock option compensation expense because they were using APB Opinion 25 accounting, they probably cared even less about reporting controls over such transactions. If so, chalk up another factor making the backtracking effort even more of a long, tough slog.

Bottom line: Wall Street is a place where even instant gratification can seem like an eternity. And the backdating investigations have been a multitude of eternities as firms evaluate their situations. The longer it takes, the more that could be wrong - but not necessarily so. Just getting the facts, and getting them right, could be a horrendous task. And it's one that firms will want to be ready for, come this year's audit season. It would be very strange indeed, if auditors weren't poking more into the records of option grants this year.