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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 afternoon, the SEC press machine announced the pending departure of Scott Taub, Deputy Chief Accountant of the Commission since the days of "The Great Enron Unravelling." Or perhaps that should be "The Great Arthur Andersen Unravelling:" if not for that sad saga, the Commission might not have snagged Scott for the deputy chief post. And that would have been a loss.

I've observed Scott in action at many EITF meetings in which I've taken part. He's been an exemplary SEC observer at those meetings, and he's represented the interests of investors well. He'll be missed.

Huron Consulting Group, the forensic accounting firm, has put together an interesting study on the presence of accounting types on the audit committees of publicly-traded firms. "Accounting types" is defined by them as:

"- an “accountant” by training and experience (this category included CPAs, controllers, accounting professors and those who served on accounting standards or other similar boards); or

- a “finance professional,” such as a chief financial officer, treasurer, finance professor."

Anyone not meeting those criteria was considered to be - a non-accountant. (Poor wretches.) The study's authors inspected the disclosures of 178 Nasdaq 100 and Fortune 100 firms, covering 700 different audit committee members from 2002 (when the Sarbanes-Oxley Act was passed) through 2005. Given that Sarb-Ox imposed more responsibility on management for producing "cleaner" financial statements, and stiffened the auditing profession at the same time, you might have expected that accounting expertise would be in demand on audit committees. Another impetus: beginning in 2003, the NYSE and the Nasdaq both required audit committees to have at least one member with enough experience to understand accounting issues as they relate to the company they serve.

"More" is exactly what Huron found in its study - but maybe not to the degree you might have expected over the four-year span. Accounting-oriented audit committee members were only 5% of the total in 2002 and their presence more than doubled to 11% in 2005. Other findings: 37% of audit committee experts didn't seem to have an accounting OR finance background, and 17% of the companies didn't appear to have an expert with either background.

What to make of the findings? To be honest, it's surprising at first that there was such a modest increase in the number of accounting types. Not that a doubling in four years is chopped liver; but given the urgency created by SarbOx, you'd have expected a bigger presence. That's especially puzzling because most of these firms should have had to deal with Section 404 testing a couple years after SarbOx's passage. Maybe many qualified accounting-type experts saw the handwriting on the wall and wanted to wait until the gut-wrenching phase of Section 404 passed. Now that the worst is out of the way, maybe they're going to pile onto audit committees. There's never a shortage of attrition from the ranks of Big Four audit partners.

A couple of years after Fannie Mae's financial reporting breakdown appeared (they still haven't filed 2004 or 2005 financials), at least one milestone is nearly complete: the separation pay package for then-CEO Franklin Raines. He's settling for $2.6 million.

Still up in the air, from this 8-K:

" whether Mr. Raines is entitled to additional unpaid base salary of up to approximately $139,000 for the period from December 2004 to June 2005;

whether Mr. Raines' employment agreement entitles him to awards under our Annual Incentive Plan for 2004 and 2005;

whether Mr. Raines is entitled to specified share amounts under our Performance Share Plan, or PSP, up to a possible maximum of 561,480 shares;

whether Mr. Raines is entitled to any shares for any award cycle under the PSP commencing in 2005; and

whether Mr. Raines' employment agreement entitles him to any additional stock options.

Final resolution of these issues is expected to be deferred until after the results of our accounting restatement are announced."

I'm sure that Fannie Mae shareholders have an answer of their own as to whether or not Mr. Raines is entitled to any of the above rewards. (Not to be printed here.) The settlement serves as a reminder that the restatement is yet to be complete; it's slipped off my radar and I'm sure I'm not the only one. It also makes you wonder if they're coming to a close on at least the 2004 statements.

At several companies with ongoing reviews of option grant irregularities, a few more executives fell from grace after the Thanksgiving holiday.

Quest Software CFO Brinkley Morse not only resigned; he refused to answer questions from the investigating special committee.

At Affiliated Computer Services, President/CEO Mark King and CFO Warren Edwards departed. Affiliated's investigation is complete, according to the 8-K; these resignations appear to be the fallout. There was no mention of restated amounts in prior financial statements. Oddly, both men still stick around in consulting roles until mid-2007 - and get to keep their options that would normally vest through the end of August, 2007, though their other unvested options are cancelled.

* * * * * * * * * *

An exceptionally good column over the weekend in the Wall Street Journal came from Herb Greenberg. Herb asks a good question: is an IPO slowdown a bad thing, as Sarbanes-Oxley foes claim? That's presuming that they're correct that Sarbanes-Oxley really is to blame for a slowdown, something that's hard to buy off on when you consider that any slowdown in the IPO market long preceded the SarbOx implementation. But Herb's answers are excellent anyway. A couple nuggets that might make you click on the whole article:

"But has anybody stopped, for just a moment, to ask whether fewer IPOs might actually be a good thing? Seriously, maybe some of these companies shouldn't go public in the first place, especially if they fear or don't want to pay for laws that are attempting to crack down on skullduggery..."


"Compared with the boom of the 1990s, the IPO market isn't so hot. But think about it: Based on everything we've been hearing lately, there's more money earmarked for untested private companies than there are places to put it. That's right: The very entities that may be looking to the public markets for an exit tomorrow -- Sarbanes-Oxley or no Sarbanes-Oxley -- are gobbling up risky-ish deals that otherwise might go public today. That, in turn, makes laws like Sarbanes-Oxley not just a good thing for investors, but a convenient scapegoat, as well."

That pretty much says it all.

I'm starting it early this week. No posts until next Monday. Going to head south, searching for some really good corn bread, some pointy boots, and maybe even a few snack crackers...

(Fans of SCOTS know what I mean.)

In the meantime, one thing for which I'm giving thanks is that I write a blog about accounting that people actually read! Thanks for coming by, and I hope you'll be back after the holidays.

Last week, PCAOB Chairman Mark Olson spoke at a Financial Executives Institute Conference on financial reporting. He gave auditors something to anticipate next month (besides their last chance to rest up before audit season): he stated that the revised Auditing Standard 2 will be released for public comment soon. And he mentioned that:

"While the PCAOB has been working on amendments to AS2, the SEC has been developing risk-based management guidance for implementing Section 404. The SEC recently announced that it will hold an open meeting on December 13th to consider recommendations regarding Section 404. Because there is great deal of value in these two initiatives being available for public consideration concurrently, the PCAOB is coordinating its release of amendments to AS2 with the SEC so that the comment periods for the PCAOB's revised AS2 and the SEC's management guidance have sufficient overlap."

So look for the AS2 exposure draft to be synchronous with the SEC guidance efforts. Will this quell the hysteria over the costs of SOX 404? Not likely. What it represents, however, is the real-world effort to move farther down the experience curve of a new process. It cannot be denied that the initial implementation of SOX 404 and the reinvigoration of the audit profession was a gut-wrenching experience for all. Nor can it be denied that it has produced favorable investor results; and it can't be denied that the entire process can be improved. This is evidence of the improvement efforts. Hopefully, it gets the chance to work.

Starbucks released its earnings yesterday, and it contained one surprise: the company had a FIN 47 adoption charge.

In the front half of this year, FIN 47 adoption charges were plentiful, as noted in this space. That's because the standard required firms to adopt it by the end of the fiscal years ending after December 15, 2005; Starbucks has one of those awkward floating year ends which happened to be late in the calendar year anyway. Their year ended on October 1, 2006, making that date the last possible day they could comply with FIN 47.

What's unusual about this? Only that it might reflect some of the biases we let creep into our thinking as investors and observers of the business scene. When you think FIN 47, many of us automatically associate it with heavy industries like mining, energy and utilities - industries where major cleanup will be needed after an asset has been consumed and the firm has a legal obligation to return a property to a "restored" state. That's what FIN 47 was supposed to do - it was effectively a jump start for firms that hadn't complied yet with their Statement 143 reporting duties. (Statement 143 is the REAL accounting standard for recording asset retirement obligations, not FIN 47. FIN 47 is merely an interpretation.)

Being in the business of serving over-rated coffee out of retail "boxes" that it leases from others, Starbucks is party to agreements that call for it to return leased property to an agreed-upon condition at the end of a lease. That obligation occurs over the life of a lease, not on its last day - and that's the obligation for which Starbucks is now accruing. Nothing startling about the size, but it just catches your attention if you're used to thinking too narrowly about accounting standards being industry-specific.

Public Company Accounting Oversight Board member Charles Niemeier delivered a speech on October 30 at the National Association of State Boards of Accountancy, in which he provided more reasons why Sarbanes-Oxley is best left alone.

Niemeier points out that while it's true that the Foreign Corrupt Practices Act of 1977 first mandated public companies to adopt effective internal controls, many companies hadn't done so by the early 1990's. Prima facie evidence: the banking sector and its early 1990's implosion. Niemeier cites the GAO findings that:

“...internal control weaknesses [were] a significant cause of bank failures” and that “[h]ad these problems been corrected, [certain] banks might not have failed or their failure could have been less expensive to the” bank insurance fund. The GAO also noted in particular that internal control weaknesses might not be detected because, under then-existing standards, auditors “need not thoroughly evaluate nor test internal accounting controls.”

In response, the FDIC Improvement Act of 1991 (FDICIA) required that certain financial institutions report to federal banking regulators on the condition of their internal accounting controls - including auditor attestation upon them. The problem was that the Act was not very specific in its requirements and the evaluation and reporting was rather lax even within the banking sector. Outside the banking sector, controls became notoriously lax. (See: Enron, WorldCom, Xerox, tech bubble, etc.)

In all the rhetoric about "unwarranted costs" of Sarbanes-Oxley compliance, an important fact is lost: the law has been effective in restoring virility to corporate internal controls. Niemeier cites a study by Audit Analytics showing that, in the first year of internal control reporting, close to 16 percent of accelerated filers reported material weaknesses. (Want evidence that the FDICIA controls weren't implemented rigorously? The proportion of FDICIA banks with material weaknesses wasn't much better than firms in other industries).

In the second year of reporting, however, over half the companies reporting weaknesses in Year 1 reported repairs of the weaknesses in Year 2. That's encouraging in its own right - but there's more. Reported weaknesses linked to restatements of past financial statements has gone from 50% in Year 1 to 37% in Year 2. And while restatements will probably hit a new record level in 2006, there's an encouraging trend within the gross numbers: restatements by companies audited by the largest accounting firms last year and are declining in 2006. In 2005, 65% of restatements were tied to the eight largest accounting firms; this year, less than half of the restatements are linked to them. The bad news, of course, is that the small firm share of restatements has more than taken up the slack. In the first half of 2006, they're tied to 497 restatements; in the first half of last year, “only” 185.

Think quick: small firms typically audit small publicly-traded companies. Small publicly-traded companies keep begging for SOX 404 relief. (And get it.) What does the restatement rate at the small end of the auditor/company spectrum suggest about internal control reporting and evaluation? Exactly the opposite of relief: more effective internal controls, and assurance from auditors that the controls are working. (For clarity: those are not Niemeier's comments. They're mine.)

Also on the less encouraging side: 69% of Year 2 weaknesses were tied to material year end adjustments - up from 53% in Year 1. There's still work to be done by companies in getting their reporting right: is cutting back on SOX 404 really the right idea? No.

In case you weren't aware of it, the SEC has added a text search function to the EDGAR database. It was released yesterday for the general public.

I've been spoiled over the years by 10-K Wizard; terrific search functionality, great report building features, and a generally all-around sweet operation. I'll be experimenting a bit with the SEC site's new capability. While I don't expect that it will exceed the friendliness of 10-K Wizard's operations, I'd be surprised if it doesn't up the ante for 10K-W and all other EDGAR repackagers to improve their own product - or risk defections to the SEC's free service.

Credit to Stephen Taub of CFO.com for turning up a fresh angle in the option backdating saga. It seems that SVB Financial, a holding company operating Silicon Valley Bank, filed its 10-Q last week and listed a new kind of risk factor in the document: its clients may face an uncertain future due to the ongoing investigations. In turn, that could lead to fairly negative implications for the bank itself, according to SVB. (They also made the same disclosure in their August 10-Q. Sometimes it takes a while to notice these things.)

The text of the entire risk factor statement:
"Many technology companies have been subject to scrutiny concerning their historical stock option grant activities which could negatively impact our client borrower market.

In recent periods, there have been several reports in the media questioning public company stock option practices, as well as a number of formal and informal regulatory investigations and other actions in connection with the historical stock option grant activities of certain companies. Many of our client borrowers utilize stock options in their employee compensation programs and, as such, could be adversely affected by these developments. Any increase in litigation, investigations or other regulatory actions which adversely affect companies that grant employee stock options, or that adversely affect the technology sector more generally, could adversely affect our client borrowers and potential client borrowers, and therefore could result in a material adverse impact on our results of operations."

That's the first account I know of that mentions an effect on someone other than the companies undergoing the investigation. Is it a valid concern - could it really "result in a material adverse impact on results of operations? Or is it more of the kitchen-sink type of disclosure that companies are fond of making? It's not hard to believe that firms lard up these disclosures so that no matter what goes wrong, they can point out that "what happened wasn't our fault, because you were warned."

Let's think that through a little bit more. The bank's clients are under investigation for improperly issuing stock options, which are an equity instrument. Maybe they run short on cash because of the cost of investigations: forensic accounting teams, outside legal counsel, and Silicon Valley witch doctors. Their stock prices get whacked because of the investigations, and they face the loss of valuable management talent - unless they compensate them well, of course. If they issue many more options for compensation, they're now going to have to record a charge thanks to Statement 123R. So...if these companies need incremental financing, whether for operations, legal defense or just plain compensation, they just might be turning to ... their friendly neighborhood Silicon Valley Bank branch. Sounds more like a positive than a negative for the bank. And it sounds like it came from the kitchen sink.