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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.

Third installment in a trilogy of healthcare providers booking SAB 108 charges; the first two were Apria and Lincare. This installment is about Matria Healthcare.

(Why do health care companies pick the weirdest, most synthetic-sounding names? They could be used by Japanese automakers, who do a pretty good job of picking weird, synthetic-sounding names themselves: Prius. Camry. Altima. Et cetera. Wait a minute - "et cetera" could be the name of a new Japanese car! Or a home healthcare provider.)

Matria's correction is not quite in the same vein as the first two. Their errors didn't have to do with early revenue recognition; instead, their errors related to understated obligations and overstated property. From their 10-K:

"... We identified two uncorrected misstatements for consideration under SAB 108, each of which was considered immaterial to our results of operations in any reporting period when using only the income statement approach we historically used to assess the materiality of unrecorded errors:

1. An unrecorded liability for drugs and supplies from a major vendor, which is included in “Accounts payable” on the consolidated balance sheets, resulted from an accumulation of unrecorded costs over several periods prior to 2003. This misstatement was identified in 2003 The amount required at January 1, 2006, to correct the liability balance would result in a $600,000 charge to our results of operations in 2006.

2. During 2006, we discovered that our medical device inventory, which is included in “Property and equipment” on the consolidated balance sheets, was overstated due to improper recording of disposed and lost medical devices and the related depreciation expense. The misstatement originated in 2003 and accumulated over subsequent periods. The amount required to correct the medical device inventory balance at January 1, 2006, would result in a $731,000 charge to our results of operations in 2006.

Under the balance sheet approach and the income statement approach, or the dual approach, we determined that correcting the above misstatements would be material to our 2006 financial statements and recorded a cumulative effect adjustment to our January 1, 2006, consolidated balance sheet upon our initial application of SAB 108."

Different causes, same effects: Matria Healthcare whacked equity by $.813 million when it adjusted its accumulated deficit for the errors. It also sounds like the Matri-archs had been noting the errors all along and assessing their materiality periodically - which is the kind of errors SAB 108 intended to be corrected with the "prior period treatment."

A while ago, I mentioned Apria Healthcare's SAB 108 adjustment to retained earnings for getting revenues recognition (and expense recognition) in line with when revenues are actually earned.

Not too surprising, then, that a similar company has a similar correction. As noted in their 10-K, Lincare Holdings has practically the same issue. Slight variation: while the issue is the timing of revenue recognition - both firms recognized revenues sooner than they should have - Lincare has an additional factor in their error. The didn't record an allowance for sales adjustments (assumed to be a form of discounting) against the accounts receivable, meaning they were overstated:

"During the fourth quarter of 2006, the Company adopted the provisions of SAB 108 effective as of January 1, 2006. During 2006, the Company identified prior year misstatements related to recognition of deferred revenues associated with rental arrangements and the recording of an allowance for sales adjustments against accounts receivable. The Company assessed the materiality for each of the years impacted by these misstatements, using the permitted rollover method, and determined that the effect on the financial statements, taken as a whole, was not material. As allowed by SAB 108, the Company elected to not restate prior year financial statements and, instead, as permitted by SAB 108, recorded a cumulative adjustment on January 1, 2006 which increased deferred revenue and allowance for uncollectible accounts by $34.4 million and $10.7 million, respectively, and reduced retained earnings by $27.6 million. Tax adjustments totaling $17.5 million were also recorded as part of the cumulative adjustment."

Note that the company found the error in 2006. They went back and assessed it according to one method - the rollover method, which is more permissive than applying both rollover and iron curtain assessments - and found that in each of the prior years, the amounts involved were immaterial and thus dodged restatements.

That seems to be the way firms are interpreting SAB 108, but not necessarily the way it was intended to be applied. SAB 108 permits the retained earnings adjustment "if management properly applied its previous approach, either iron curtain or rollover, so long as all relevant qualitative factors were considered." That makes it sound like the Commission meant if the errors had been assessed all along - not just discovered in 2006 and retroactively assessed the way they would have been had the errors surfaced before.

Back on the Island of Weird SAB 108 adjustments...

Another positive adjustment to beginning 2006 retained earnings is disclosed in Triarc's 10-K It also contains one of the better descriptions of how the firm assessed the ongoing errors before SAB 108 and waived the adjustments: it's an actual statement that they'd assessed a particular error using the rollover method, enabling them to pass on it.

Triarc had three elements in its SAB 108 adjustment - rather befitting for a firm named "TRI-arc", eh? In summary:

A deferred gain on the sale of "certain non-strategic businesses, four of which did not qualify for accounting as discontinued operations" was closed out to retained earnings in the adjustment. The gain had been deferred on the sale because of "(1) uncertainties associated with realization of non-cash proceeds, (2) contingent liabilities resulting from selling assets and liabilities of the entity or associated with litigation or (3) possible losses or asset write-downs that might result related to additional businesses anticipated to be sold." By 2002, those mysteries were solved and the company should have eliminated the gain by then. Better late than never...

Triarc insurance proceeds in 1993 for damages to its then-corporate office building. Because of contingencies tied to litigation with the landlord, the gain was deferred. Once again, those contingencies were cleared by 2002 and the gain should have been recognized by then.

Finally, the company had over-accrued for medical program self-insurance. Those overaccruals should have been cleared by 2002.

In total, the accumulated adjustments tacked on $5.2 million to the opening retained earnings of $395 million. These SAB 108 adjustments are starting to feel like the corporate equivalent of finding loose change under the living room sofa cushions: they accumulate for years, they're nice to find, but they don't change one's wealth very much. While the loose change can be attributed to seating ergonomics, however, the SAB 108 adjustments seem to attributable to just plain lack of attention to detail.

Devotees of the show "Lost" know what I'm talking about...

Back on Wednesday. Tentatively.

Finally, a "normal" sort of SAB 108 adjustment... normal, at least, in the context of what you'd expect.

Home healthcare provider Apria Healthcare Group went the cumulative-adjustment group in their 10-K filing for 2006, with their correction of revenue recognition. It's exactly the kind of error you'd expect to see corrected a la SAB 108: a known error for years, immaterial when viewed one way - the rollover method, in this case - but material when you look at it in the context of the iron curtain.

(If the terms "rollover" and "iron curtain" leave you scratching your head, click here for some help.)

Apria's issue: they bill customers monthly for the use of equipment. That monthly bill is actually a prepayment on the part of the customer for the right to use the equipment for a month - but unless that billing takes place on the first day of the month, a portion of the billing is for revenue to be recognized in a subsequent month. Apria recognized revenue based on the billing, instead of the period in which the service was actually provided. The expense associated with those revenues also get recognized out of synch with the period in which the service is actually rendered, too. Net effect: early revenue and expense recognition.

To correct it, Apria established a deferred revenue account for $32.3 million and a deferred expense account for $22.7 million, implying about a 30% gross profit on such services. The after-tax effect hitting retained earnings: a charge of about $5.5 million. While any one year's error might have been immaterial, catching up those all of the errors would have been material to any one year's earnings.

A pretty basic principle - match revenues/expenses with the periods in which they're earned and incurred - now being applied properly because of the amnesty provided by SAB 108. One wonders what would kind of scenario would instigate corrections everywhere if SAB 108 hadn't come along.

CBL & Associates Properties, a shopping mall REIT, made a SAB 108 adjustment to its beginning-balance retained earnings when it filed its 2006 10-K. And as you'd expect by now, the adjustment was positive - it added to the retained earnings balance.

Also, as you'd expect by now, the amount involved was slight - $2.4 million or about 2% of the beginning balance of the retained earnings. In the end, it was mostly due to a reclass out of retained earnings ($7.2 million) into additional paid-in capital ($9.6 million). The difference between the two was the deferred tax asset effects.

CBL had "incorrectly recorded the realized tax return benefits of excess stock compensation deductions as reductions to income tax expense rather than as increases to additional paid-in capital and minority interest liability." Net result of that kind of recording is to overstate retained earnings and understate paid-in capital. It's the first instance noticed of this kind of error - but it still continues the string of SAB 108 positive corrections.

Monday, AES Corporation issued a non-reliance 8-K covering its financials for 2006 to date and the years ended 2005, 2004, and 2003.

The company is still investigating, but it will restate for a variety of reasons. From the 8-K:

"The errors identified by the Company relate primarily to the following categories, which may change before the accounting review is finalized:
· Accounting for derivatives
· Capitalization
· Certain errors, including depreciation adjustments in the Company's subsidiaries, C.A. La Electricidad de Caracas and AES Eletropaulo
· Share-based compensation, including stock option and restricted stock unit awards
· Income tax expense

Many of these errors were identified as a result of the Company's continuing remediation of previously identified material weaknesses. Other errors were discovered during the Company's quarterly and year end accounting reviews. All errors that have been presently identified result in non-cash adjustments."

Note the near-obligatory mantra: "All errors that have been presently identified result in non-cash adjustments." That doesn't mean they won't matter: it'll be interesting to see how widely the revised earnings vary from the original. And it's interesting to note that the errors were uncovered during the remediation of control weaknesses noted in the 2005 audit. The "Controls" part of last year's filing listed an amazing number of flaws, and you can see how it took over a year to work them all out. The late filing for 2006 and revocation of the prior years' financial are just more evidence that internal controls matter... to companies of all sizes.

Another SAB 108 adjustment regarding interest capitalization pops up in the 10-K filing of General Communication Inc. (The other one noted recently was in the 10-K filing of Deltic Lumber.) Like the Deltic Lumber correction, this one had a favorable effect on retained earnings.

Check this explanation:

"Prior to January 1, 2006, only the interest costs incurred during the construction period of significant capital projects, such as construction of an undersea fiber optic cable system, were capitalized. Beginning January 1, 2006, we modified our interest capitalization policy resulting in the capitalization of material interest costs incurred during the construction period of non-software capital projects and the capitalization of interest costs incurred during the development period of a software capital project.

These misstatements accumulated over several years and were immaterial when quantifying the misstatements using the statement of operations method. Upon adoption of SAB No. 108 on January 1, 2006, we recorded a $3.5 million increase to property and equipment in service and $1.6 million increase to accumulated depreciation for the cumulative misstatement as of December 31, 2005. Accordingly, we increased retained earnings by $1.1 million and recorded $772,000 as a long-term deferred tax liability."

It's a pretty minor amount - less than 1% of beginning retained earnings, and the adjustment to PP&E is less than 1%, too. It sounds as if the firm made a policy change as of 1/1/2006, then looked back to see what the effect would have been had the proper policy been in place all the time. It's not clear that they were examining the differences between policies all along up until the time they changed it. And when they did, the change still didn't come up to a material amount.

General Communication appears to have defaulted to the retained earnings adjustment approach - something that seems pretty common. But check this excerpt from SAB 108:

"The staff will not object if a registrant does not restate financial statements for fiscal years ending on or before November 15, 2006, if management properly applied its previous approach, either iron curtain or rollover, so long as all relevant qualitative factors were considered."

If a firm was quantifying its errors all along and waiving them, and application of SAB 108's dual approach results in a correction, then the retained earnings adjustment is just fine. But if a firm makes a correction to its policy in 2006 and hadn't been quantifying it all along prior to that change, it could be argued that the retained earnings adjustment is not the right way to go. But it seems like pretty much all companies have taken the retained earnings route, ignoring the fact that restatement is preferable and that immaterial items should simply pass through earnings.

Time for a break from the drone of SAB 108 adjustments... I'll drone instead about the internal controls report in the General Motors 10-K filed last week. The media has jumped on this one because of the sensationalism of the disclosures: the lack of controls over internal reporting and the government investigation of GM's accounting actually made it into the "Risk Factors" section of the 10-K. Maybe you'd expect that from a start-up - but not from a storied company the size of GM. Go to section 9A, "Controls and Procedures," and you'll see the whole management report on the internal controls. A couple bars go like this: "1. The Corporation lacked the technical expertise and processes to ensure compliance with SFAS No. 109, Accounting for Income Taxes, and did not maintain adequate controls with respect to (a) timely tax account reconciliations and analyses, (b) coordination and communication between Corporate Accounting and Tax Staffs, and (c) timely review and analysis of corporate journals recorded in the consolidation process... 2. The Corporation in certain instances lacked the technical expertise and did not maintain adequate procedures to ensure that the accounting for derivative financial instruments under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, was appropriate. Procedures relating to hedging transactions in certain instances did not operate effectively to (a) properly evaluate hedge accounting treatment (b) meet the documentation requirements of SFAS No. 133, (c) adequately assess and measure hedge effectiveness on a quarterly basis, and (d) establish the appropriate communication and coordination between relevant GM departments involved in complex financial transactions... 3. The Corporation did not maintain a sufficient complement of personnel with an appropriate level of technical accounting knowledge, experience, and training in the application of generally accepted accounting principles commensurate with the Corporation's complex financial accounting and reporting requirements and low materiality thresholds... 4. Due to the previously reported material weaknesses, as evidenced by the significant number and magnitude of out-of-period adjustments identified during the year-end closing process and the resulting restatements related to deferred taxes and hedging activities, management has concluded that the controls over the period-end financial reporting process were not operating effectively. Specifically, controls were not effective to ensure that significant non-routine transactions, accounting estimates, and other adjustments were appropriately reviewed, analyzed, and monitored on a timely basis..." A handful of observations: Anyone still in college and reading this blog, take note (all three of you): General Motors doesn't seem to have a lot of technical expertise on hand when it comes to complex accounting matters. The first three weaknesses discussed above all had a common thread - a lack of technically competent personnel. It's not just in Detroit, folks. This is one of the most common weaknesses you can observe if you spend time reading these control reports. That's a great thing for people looking for a career in accounting. (Of course, finance is sexier and sounds cooler to the opposite sex than accounting, especially in your college years. Who needs accountants? Why, the world simply cries out for more investment bankers! Sober up, finance students. If you really want to go where your talents are needed, and the future looks bright, think about accounting.) Don't blame GM's problems on "complexity." General Motors is a great big consenting adult of a corporation. It engages in business in many taxing locales, and it voluntarily chose to use derivatives. If you're going to do things that involve complex transactions that are hard to communicate to your shareholders, be prepared to account for them the right way. Underinvestment in accounting and finance staff saves dollars in the short run - but costs the firm's reputation dearly in the long run. In this regard, General Motors is no different than so many other companies who've come up short in the controls-over-reporting department. Financial reporting is a cost center, for crying out loud: the natural managerial instinct is to starve it. Managers do not lay awake at night worrying about the configuration of accounting and finance departments the same way they'd fret over the layout of the marketing function or the advertising budget. Those functions make money for the company whereas accounting and finance are often viewed as a drain - until it's time to do the work over again (see "Restatement Zoo" link at right). Then the new accounting and finance people are pretty important. For a while. Corollary and conclusion: it's a management problem. But it's so much easier to just blame accounting for being too demanding. Again, this is not to single out GM as particularly inept. It's just that it happens to be one of our country's biggest firms and employers, and this scenario has played out in so many other instances over the past few years. This is a sprawling giant of a company, a management challenge all its own in every department. It's apparent from these weaknesses that insufficient managerial attention was given to managing the accounting and finance function. General Motors has taken some big strides towards pulling its finance staff out of the muck and onto the track; it discusses them in Section 9 as well. It would be great to see other companies face up to their underinvestment in controls and accounting personnel. After all - what's good for GM is good for the United States too. ...

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The streak of favorable 108 adjustments continues...

Gartner, the technology consulting firm, came clean with its 10-K application of SAB 108, and increased its retained earnings by a bit less than 2%. More striking: some of the adjustments also affected additional paid-in capital, and in total, the SAB 108 adjustment increased stockholders' equity by 7%.

The biggest piece of the favorable increase to retained earnings - $7.4 million - came from a previously overstated income tax payable balance. According to the filing, "The adjustment was due to the carryover impact of an excess payable balance from prior years in the current taxes payable account which had accumulated over a period of years prior to 2000." What made the current taxes payable too large is still unclear.

The most curious item in the SAB 108 stew had to do with stock option pricing:

"Prior to October 1999, the exercise price of stock options granted to employees under the Company's stock option plans was equal to the average of the closing price of the Company's common stock for the five trading days immediately preceding the grant date. In 2006, the Company determined that for valuation purposes, the exercise price should have been the closing price on the date of grant (which is the formula used by the Company since October 1999). Accordingly, the Company revalued options granted prior to October 1999 using the closing price on the date of grant and determined that an additional $6.0 million of compensation expense should have been recorded. The cumulative effect of the adjustment resulted in a reduction in opening accumulated earnings of approximately $3.8 million, an increase to additional paid-in capital of $3.9 million, and a tax effect of less than $0.1 million."

Using SAB 108 to clear up stock option problems is not what the SEC probably had in mind when it published the bulletin. The Commission's intent, I believe, in developing SAB 108 was to motivate companies to eliminate known old errors that had accumulated on balance sheets for years. If a company just figured out in 2006 that there were problems in its option practices, restatement might be a more appropriate route, or at least the disclosures discussed in the recent letter sent from the Division of Corporation Finance to companies with known option reporting issues.