|
|
The AAO Weblog covers accounting issues and current events as they relate the practice of investment analysis. All posts prior to September, 2007 are in the public domain, but after September 4, only subscribers to The Analyst's Accounting Observer will see all posts going forward. Only selected, occasional posts will be released to the public domain from September 4 forward.
Subscriptions to full posts available for $500 annually.
|
 |
| AAO Weblog (Public)
|
|
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. |
|
"Lucky Strikes" II
|
|
|
By Jack Ciesielski on
10/31/2006 8:40 AM
|
|
|
Now that my coot attack has subsided, let me tell you about one of the more interesting exchanges during the conference. It encapsulated a lot of the "who's at fault discussions" going on. And it brought out an interesting angle on auditing that perhaps should be pursued by the Big Four auditors.
Moderator Katherine Schipper asked PCAOB board member Daniel Goelzer if the PCAOB will take auditors to task in their reviews of registered auditing firms, for not noticing backdated options in the first place. Goelzer's answer: there are understandable reasons for missing the misdating. Most of these firms were using APB Opinion No. 25 accounting for their option plans with a resulting compensation balance of zero being reported. Why would they spend much time and effort auditing such an amount if they didn't suspect malfeasance in the first place?
(Not discussed: during the periods in question in the backdating scandals, the auditing business was a much different animal than it is now. Post-Sarb-Ox, there's a lot more focus on documentation, and no "cross-selling" efforts between auditors and the consulting side. Pre-Sarb-Ox, it was a lot wilder and woolier. When we look at the issue now, I'm not always sure observers remember that today's auditors are much more sober bunch than what existed in the heyday of backdating.)
Ms. Schipper then asked if the auditors should have caught the misdating of their audits of footnoted Statement 123 information. Theoretically, auditing that footnote information vigorously could have uncovered contracts with incorrect dates - and this has been a fixture of financial statements since 1996. The whole thing could have been avoided. Goelzer's reply was that an audit is an document-driven process, and most auditors might have had no reason to believe that the documents they were examining were false at the time. Another member of the panel, Peter Klinger of BDO Seidman, chimed in that auditors don't usually devote the same amount of attention to footnotes as they do to financial statement amounts. (I think Goelzer agreed with him.) That's not a comforting thought to investors who often rely on the footnotes as much, if not more than, the actual financial statement amounts.
Professor David Larcker, one of the conference organizers, reminded the panelists that there was a body of academic literature existing as far back as 1997 showing that opportunistic pricing of options had been found. (Surprise: Erik Lie was not the first academic to discover it. Take a look at "Good Timing: CEO Stock Option Awards and Company News Announcements" in the Journal of Finance, Vol. 50 No. 2, June 1997. Available on the SSRN Network.) Why didn't the auditing profession take note and sharpen their focus on option awards?
Good question, and no really clear answer emerged from the discussion. My own interpretation: we're looking at things with perfect hindsight, and everything looks so obvious when you look at the past. For instance, some of the graphs shown at the conference were amazing: it was a plot of cumulative stock returns before and after the grant date of options for a sample of 7,786 grants from 1,970 companies from 1996-2005. Wish I could show you the graph here, but let me just say that it looked a lot like a "V": the returns sloped down just before the award date, then sharply curved upward. That's not a small sample either: the sample covered approximately 89% of the U.S. market capitalization. Shouldn't it be obvious to auditors?
Well - no. We're looking at the forest now, with perfect hindsight. And auditors, if they were looking at all in the late 1990's were looking at trees, and probably not too closely. You almost have to ask why everyone didn't notice - investors and regulators included.
That's not an excuse for auditors: Larcker's point is a good one. Maybe auditing firms do look at the academic literature for an auditing advantage already - but if they do, they seem to have missed a pretty good way to have sharpened up their auditing processes. After all, as the investigations now show, the SEC uses academic literature for scoping things out. (Lesser-known example: Professor Carol Marquardt of Baruch College brought regulatory attention to EPS management through her work on the infamous "CoCo" bonds.) Maybe the Big Four's national office think tanks will recruit more heavily from the ranks of academe in the future.
|
 |
|
|
|
|
|
"Lucky Strikes"
|
|
|
By Jack Ciesielski on
10/31/2006 7:38 AM
|
|
|
Spent the day yesterday at one of the best train stations in the country: Union Station, Washington DC. Why? The Arthur and Toni Rembe Rock Center for Corporate Governance, a joint effort of Stanford Law School, Stanford's Graduate School of Business and the Engineering School, held a conference entitled "Lucky Strikes: Public Policy Issues in Backdating and Springloading." Catchy, eh?
The conference featured speeches by SEC chairman Christopher Cox and enforcement director Linda Chatman Thomsen. No surprises in either speech, really. (Although it was the first time that I'd heard anyone trace the rise of options issuance back to the employee stock option plans of the 1980's when they were part of the anti-takeover landscape. That was an assertion of Ms. Thomsen.) More than just speeches by SEC staff, the conference was a feisty (well, to an accountant) blend of commentary and discussion from academics, members of the law profession, and other regulators like the PCAOB's Daniel Goelzer.
The conference covered more than I can cover in a single posting. After hearing about the problems that can be caused by even automatic grant plans and transactions in options during blackout periods (if the managers know that there's material information afoot, shouldn't they halt the auto-pilot transactions? Or depend on the auto-pilot as a defense?) and the varying length of blackout periods (there's little uniformity from company to company, and it's unclear why it should vary) and prepaid variable forwards (contracts that let executives get upfront cash from their option/stock holdings by pledging them for delivery in the future - without reporting a sale in the exec comp reporting regime), I'm more convinced than ever that most option plans inherently work against the long-term equity investor and no amount of regulation will change that.
|
|
|
|
|
|
|
|
Statement 133 Tutor Needed: The Princeton Review
|
|
|
By Jack Ciesielski on
10/30/2006 5:01 AM
|
|
|
The Princeton Review, sponsor of the leading SAT preparation course in the United States, needs a little refresher course in Statement 133. (And it has lots of company. Statement 133 has been a sore spot for companies over the last twelve months, generating many restated financial statements.)
The company filed a non-reliance 8-K on Friday, due to "embedded derivatives" in an issue of preferred stock that need to be de-embedded and accounted for as stand-alone derivatives. Why? That's because Statement 133 requires contracts for financial instruments to be evaluated by the issuer to see if they contain derivatives that wind up getting historical cost treatment just because they're plopped into just such a contract. Put it this way: a company might enter an onerous derivative contract that would have to be accounted for at fair value, with the result that investors would see changes in that contract each quarter. To avoid that, the terms of the derivative might be embedded in another contract - like preferred stock or convertible debt - that doesn't get re-measured at fair value. Statement 133 prevents such end runs by requiring separation of such an embedded derivative from a host contract when all three of these conditions are met:
The economic characteristics and risks of the embedded derivative instrument are not clearly and closely related to the economic characteristics and risks of the host contract.
The contract containing both the embedded derivative instrument and the host contract is carried at historical cost unless GAAP requires it to be carried at fair value with changes in fair value reported in earnings.
If the embedded derivative instrument was a separate instrument in the first place, it would be considered a derivative instrument under Statement 133.
The company issued convertible preferred stock in June 2004 - without the proper separation of embedded derivatives. It also issued warrants which should have been classified as liabilities, instead of equity. The firm hasn't finalized its figures yet, but from the ranges given in the 8-K, it looks like reclassification will slightly improve the net loss in 2004, increase it in 2005, and improve it again slightly in 2006. The balance sheet is more leveraged in 2004, less leveraged in 2005, and unchanged in 2006.
It's already a fair value reporting world, and only likely to become more so with the issuance of Statement 157, "Fair Value Measurements," which will pave the way for more fair value reporting standards. Statement 133 was one of the more broadly-sweeping fair value standards issue to date. Before new ones get issued, the SEC might be doing some broad sweeping of its own to make sure that current GAAP is being followed before new fair value GAAP arrives.
|
|
|
|
|
|
|
|
NEC Goes On GAAP Hiatus
|
|
|
By Jack Ciesielski on
10/27/2006 7:07 AM
|
|
|
Interesting 6-K filing by Japanese electronics giant NEC: it seems that the company is having trouble preparing its financial results on a United States accounting principles basis. This isn't something new challenge for NEC, so it's a little unusual to see it happening now.
The company will be reporting results on a Japanese basis for the current year; they gave no indication that they'd be switching back to U.S. GAAP. NEC's financials for the fiscal year ending March 31, 2006 were audited by Ernst & Young ShinNihon under Japanese auditing standards - not the same standards as required in the United States by the Public Company Accounting Oversight Board. After the report was filed with the Japanese regulators, the auditors "requested further analysis" for a revenue recognition issue; this caused a delay in filing the firm's 20-F with the SEC, and was announced on September 28. It still will file (eventually) the 2006 20-F on a U.S. GAAP basis; although they make no commitment to further filings, it would be strange not to continue reporting on a U.S. basis once the bugs have been worked out.
The company admits that it will take "considerable time" to prepare its financials on a U.S. basis for the first half of fiscal 2007 (the current year) because of the problems in getting resolution on 2006. So, it's switching to Japanese GAAP in its future financial releases. Needless to say, this is going to hose the analysts who have been following the company on a U.S. basis - and don't know reporting under Japanese GAAP.
What's the hold-up? Being a foreign issuer, NEC doesn't report on its internal controls yet. But the auditors have found problems neverheless: The September 28 filing states that the current internal controls do not "ensure that all significant U.S. GAAP adjustments and reclassifications, presentations, and disclosures" are included in U.S. GAAP financials; the company lacks specific policies and procedures for dealing with transactions under U.S. GAAP; and the company lacks personnel with the "appropriate knowledge, experience, and training in the application of U.S. GAAP at its headquarters' corporate controller division or its various business units and subsidiaries."
Damning stuff, and not uncommon in the United States when firms were going through their first Section 404 reviews. The net result of those weaknesses led to the delay in filing: problems were found in revenue recognition, income taxes, accruals and reserves, and research and development expenses. Basically, in much of the income statement.
The real sticky issue, as noted in yesterday's filing seems to be the revenue recognition issues in NEC's "IT Solutions" group. Apparently, this is a services group that enters into customer arrangements that have more than one facet to them: the firms is committed to delivering multiple elements of a contract over various stages of an agreement's life. The iron rule of revenue recognition (one of the iron rules, anyway) is that you don't recognize revenue before you've delivered goods or provide services - even if you've been paid in advance. NEC's auditors "requested further analysis to support the relative fair value of maintenance and support services provided as part of multiple element contracts": it's what's needed to parse out the different components of a contract, each component with a possibly different revenue recognition pattern. So the relative fair values of each can ultimately have a big impact on the timing of revenue recognition. Given that these contracts often span more than one year, it's not unlikely that there could be issues with previous years' documentation that have an effect on FY 2006 also. That would only add to the time needed to finish the job.
|
|
|
|
|
|
|
|
More Long Looks Back
|
|
|
By Jack Ciesielski on
10/27/2006 6:00 AM
|
|
|
F5 Networks filed a non-reliance 8-K on Wednesday; MIPS Technologies also filed a non-reliance 8-K that day. I'll cut to the chase: both companies announced that they'll be restating back as far as 1999 when they're finished their investigations of options backdating.
That's on top of a few other recent disclosures (Monster, Integrated Silicon, Valeant Pharma) that their revisions will be presented on a restated basis rather than a catch-up basis. F5 and MIPS won't be restating as far back as the others but back to 1999 is still a long time.
It's safe to say a pattern is emerging: if you buy off on these plans, restatements will be done on a fully restated basis - something that would be much more useful for investors trying to assess how far off base managements led them during the "anything goes" years. (At least for this week, there's a pattern. More informal monitoring to come.)
|
|
|
|
|
|
|
|
Ford Joins The Derivatives Do-Over Crowd
|
|
|
By Jack Ciesielski on
10/26/2006 6:38 AM
|
|
|
Old news now, but worth a mention anyway: Ford announced on Monday that it would be restating its financials from 2003 to 2005 in an amended 2005 10-K (and the "selected financial data" therein, from 2001 to 2005) for incorrect accounting related to derivatives. Per the 8-K filing:
"During the preparation of its response to a comment letter from the Division of Corporation Finance of the Securities and Exchange Commission a routine review of its Annual Report on Form 10-K for the year ended December 31, 2005, our indirect wholly-owned subsidiary, Ford Motor Credit Company ("Ford Credit"), became aware of a matter related to accounting for interest rate swaps under Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended ("SFAS 133"). Specifically, Ford Credit discovered that certain interest rate swaps it had entered into to hedge the interest rate risk inherent in certain long-term fixed rate debt w | | | |