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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.

One of my favorite things is to get a chance to write a piece in one of my favorite publications, Barron's.

They gave me the chance to write this weekend's guest editorial. I discussed a few things mentioned in OFHEO's recent report on its two wards, Fannie & Freddie.

If you're interested and you have a subscription to Barron's, you can link right here.

Interesting development in London, as reported in the Financial Times: Grant Thornton and RSM Robson Rhodes plan to combine operations.

The combined firm would be the next largest firm after the Big Four, but a distant fifth: its combined revenue last year would have been only one-third of fourth-place Ernst & Young's.

The Big Four aren't making up contingency plans, one would think, but it's a healthy development for those who are concerned that the Big Four might become too complacent about their place in the world - and the kind of audit quality that comes from complacence. There's no reason to think that there aren't more combination possibilities at the lower end of the audit world - possibilities that would only be encouraged by regulators. The Big Four, on the other hand, might not get such friendly regulatory receptions if they try to make any more acquisitions of significant size.

The subject of operating lease restatements has been beaten so thoroughly, it's hard to believe that there are any companies left with this problem.

Not impossible, though. One turned up yesterday: REIT AvalonBay Communities put the non-reliance tag on its financials for the fiscal years 2006, 2005 and 2004 and the quarterly filings for 2006, to boot.

What happened? AvalonBay believed it was within the bounds of SFAS 13's "reference to an alternative basis to straight-lining over the full term of the lease" by straight-lining its land lease expense over the historical and expected average holding period of communities - about the same as the current payments under the lease. Reconsidering the policy after seeing other companies examine their land lease accounting, AvalonBay figured it might be more in line with SFAS 13 to straight-line land lease obligations over the full term of the lease, ignoring the expected holding period.

Bottom line effect: the company expects to report "a reduction of net income available to common stockholders from amounts previously reported of approximately $11.9 million for each of the years ended December 31, 2006, 2005 and 2004, respectively, or a reduction in the previously reported net income available to common stockholders of 4.4%, 3.8%, and 5.7%, respectively." Wonder if there are more of these revisions still lurking out there? The issue was pretty much a hot topic two years ago...

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Yesterday's post mentioned the SEC's forthcoming proposal to give US companies a choice of using international (IASB-issued) accounting standards or US (FASB-issued) accounting standards. The natural question: if this happens, what is the FASB's future? My crystal ball is kind of cloudy right now, although I think there's still going to be some kind of accounting standard-setting organization in Norwalk no matter what happens. Better idea: read Marie Leone's take on the FASB's future based on a recent industry presentation made by FASB Chairman Bob Herz at Pace University's School of Business in New York. Link here.

Things are starting to get interesting at the SEC after a bit of a lull. It seems like there hasn't been much going on except for lots of hand-wringing over the reputedly high costs of Sarbanes-Oxley compliance for small companies.

That may be changing. Not the hand-wringing over the reputedly high costs of Sarbanes-Oxley, just the fact that not much else seems to be going on.

First of all, there was the filing of charges against Apple's former general counsel and chief financial officer for their roles in the Apple option backdating case. The pair had alleged to have known their actions would under-report Apple's compensation expense by $40 million. Former General Counsel Nancy Heinen hasn't responded to the charges yet; former CFO Fred Anderson simultaneously settled with the Commission for $3.5 million without admitting or denying the charges. You could argue that still, nothing much is happening at the SEC: Anderson will be permitted to participate in the management of public companies, and in fact continues to serve as the audit committee chairman of the board of directors at Ebay. Rather paradoxical position, for someone who stood to gain from letting misreporting occur.

Then there's this article, courtesy of Reuters, where Chairman Cox declares that there will be a conclusion to the backdating saga "within weeks." Hopefully, the conclusion will be more vigorous than what we've seen so far.

And lastly, there's the sudden activity in international accounting standards going on at the SEC. First, there was the announcement on April 24 that the SEC will float a concept release this summer giving registrants a choice between US and international accounting standards in their filings with the Commission. Then the next day, just to amp up the action a bit further, the SEC signed a protocol for a "Work Plan" between the Commission and the Committee of European Securities Regulators (CESR) to share information on application of International Financial Reporting Standards (IFRS) by issuers listed in the UK and the U.S.

That last one could have a lot more effect on the work of investors than the SEC's handling of the backdating issue; it's the one to watch over the coming months.

It hasn't happened yet, but in today's climate, there's no reason it won't: buyout rumors are swirling around Bausch & Lomb for the past few days. The company's stock hit a 52-week high on Monday, up almost 10% as .

No comments here on the investment merit of the stock. There should be some questions about fairness to public shareholders, though, in the event of a buyout: the company hasn't filed a 10-Q since July 2005. It finally filed its 2005 10-K in early February 2007. If it doesn't file its 2006 10-K by April 30 - or obtain waivers from the terms of its public debt, as outlined in this late filing notice - it'll be in default on its debt and face acceleration.

So - there is a pretty big information gap between the company and its public investors.

It's obvious that the easy way to solve the problem for the company's managers would be to sell the firm. Let someone else worry. But any deal involving management would seem to open up more than the usual conflicts of interests in a management buyout: they'd be the only ones having a real grip on the firm's financial parameters, putting the public shareholders at a serious disadvantage in terms of fixing a fair price. Even a deal with another firm would be tough to pull off fairly: while a buyer might get to have a look inside the firm, they'd be at a distinct advantage to the public shareholders too. Stay tuned. Maybe it's just rumor, but if it turns out to be true, it could be pretty interesting.

Referring to the bit I wrote on the Grant Thornton survey on the expected usage of Statement 159, reader Patricia D. had this to say about my comment that it seemed strange that "14% of those surveyed said they'd use Statement 159, but only 5% said they'd early adopt 157" - strange in that you can't do an early adoption of 157 without simultaneously adopting 159.

Patricia points out that "the article didn't state that the 14% were expecting to adopt 159 early. Couldn't it be that the remainder of respondents who are planning to make use of the fair value option but aren't planning for early adoption with standard 157 are just going to wait for the effective date?"

Right she is. In all the excitement surrounding Statement 159 (excitement for some of us, anyway) I didn't take the article the right way. It really didn't say that the 14% were early adopting 159, just that they were considering adopting it. On the other hand, it seems a bit surprising to me - based on the buzz surrounding the topic lately - that only 5% of those polled said they were considering early adoption. I guess it depends on who you're polling -but there's no additional color at this time on the Grant Thornton press release web page.

SEC Commissioner Paul Atkins delivered a speech last week at a conference co-sponsored by the American Enterprise Institute and the Brookings Institution; classic Atkins stuff, like this rhetorical monologue on Section 404 examinations:

...Take, for example, the debate around the implementation of Sarbanes-Oxley section 404. Most people have now concluded that Audit Standard 2 of the PCAOB has been a failure — the costs exceed the benefits, especially to smaller companies. However, I still hear people say in this debate that "If you cannot afford to do a real 404 review, you should not be a public company." If that is true, who should make that decision? Politicians, regulators, or bureaucrats? Or investors? In fact, our actions in calibrating the standards for management, accountants, and lawyers in performing internal control reviews and assessments create barriers to entry to some number of companies. Some may decide that going public is not worth it and others may decide to go public elsewhere. Is that good for investors?...

Fair question, that one about "who should make the decision to be a public company." It should be answered by the managers of the company who are deciding to turn ownership over to the general investing public at large - who are the new bosses after an IPO. Are they ready to have systems in place to report faithfully to the new owners of the company? They should be - and that's all the law asks of them. They're in the best place to make that decision. Is it good for investors if such managers go elsewhere? Well, they sure aren't hurt if managers who won't be basically responsible to them (that is, who won't take steps to ensure faithful reporting to them) aren't part of the investment landscape.

There's a different angle in his speech as well, and a very ironic one. He argues that Staff Accounting Bulletins (SABs) are subject to review under the Administrative Procedure Act - something that would dramatically impede the SEC's ability to widely disseminate their positions on application of accounting problems they've observed in practice. SABs are the result of observations by SEC reviewers and the Office of the Chief Accountant; sometimes they deal with new standards (see SAB 107); sometimes they deal with problems observed in practice over many years (see SAB 108). They are always the result of observed reporting issues, and they are issued in order to keep all registrants on the same page, accounting-wise. They're not loved by companies, because they can force them to change things. Putting them into an Administrative Procedure Act would slow down their issuance even further. Atkins' take:

... I have no opposition to our staff's attempting to explain or apply an SEC rule or accounting standard to a current situation. Staff guidance can provide very helpful advice to all participants in the capital markets. Such guidance can be issued faster and is particularly appropriate to situations with a unique set of facts and circumstances.

But sometimes staff pronouncements can fundamentally change existing market practices. For example, Staff Accounting Bulletin No. 101 (SAB 101) addressed in depth various aspects of revenue recognition. The final guidance required registrants to reflect the adoption of SAB 101 as a change in accounting principle, similar to the adoption of a new FASB standard. With all of the attributes of rulemaking from the perspective of affecting the marketplace, it is difficult to argue that such pronouncements are not rules and should not be subject to the requirements of the Administrative Procedure Act.

SAB 101 was nothing new: it was a compendium of revenue recognition issues pulled from existing accounting literature, and a description of the SEC's take on various misapplications of them. Not all companies had to "change accounting principles" to comply with it, and those that did, probably weren't employing the proper principles in the first place. Sounds like another front is being opened in the battle to tamp down fair reporting to shareholders.

A story on Yahoo! Finance about a Grant Thornton survey of controllers and CFOs showed that "less than 15 percent (14.18%) say they plan on making use of the fair value option."

Hmm. That's not inconsequential at all: it could be enough to introduce non-comparability into the broader financial reporting landscape.

On the other hand, the story doesn't mention the survey size, or the survey technique. And there's no full length story on the Grant Thornton website - at least not in the press room section - that might flesh things out a bit more.

Of those responding "yes, we're going for it", 84% said they expected to apply the option to financial investments and 68% said they'd apply it to equity method investments. Firm commitments will get the fair value treatment, said 68% of the respondents. But less than half said they'd be applying it to the debt issued by their own firm.

The one weird finding was to this question: "Early adoption of the fair value option is permitted only if Statement 157, Fair Value Measurement, is also adopted early. Do you plan to adopt Statement 157 early?

Yes, said 5.97 % of the respondents. No, said the rest. If the two standards (157 and 159) must be adopted simultaneously upon choosing the fair value option, how can 14% expect to take the option without early adopting 157? It's possible they don't understand that you can't do one without the other. That's not a comforting thought.

Yesterday, the PCAOB released its report on the study of 275 examinations of internal control audits performed by auditors engaged to report on 2005 financial statements. Their findings are a bit dated, but about as timely as can be: the 2006 audit season is just now finished. The tuna doesn't just swim into the can, and you can't report on 2006 audits until you've inspected the work.

Their findings might not be terribly startling: yes, there's room for improvement in the way auditors audited internal controls. Keep in mind however, that these reports covered the second year that Section 404 reviews were being performed. Auditors were still sliding down that learning curve. In fact, the report specifically states that "progress was made in improving the efficiency of internal control audits. Many of these improvements resulted from the easing of time constraints that auditors and issuers faced in the first year, issuers' and auditors' additional experience..." Which is the way it's supposed to go, and has.

Nevertheless, the Board's examiners found room for improvement in some key areas. From the report:

Some auditors did not fully integrate their audits; that is, they didn't mesh their internal control study findings with their plans for auditing the financial statements.

Some auditors failed to apply a top-down approach to testing controls. (They didn't pick the most critical areas for testing first.)

Some auditors assessed the level of risk only at the account level - which led to more detail work than perhaps was needed.

Some auditors could have increased their use of the work of others - which naturally, could have sped things along.

The examiners also found that some auditors didn't make use of rule guidance that relieved them of some of the required assessments in the original standard (Auditing Standard 2), which is itself now in the midst of an overhaul.

The findings aren't terribly surprising: given that the exams were of a second-year step in a long overdue process, you'd expect that auditors are still finding their feet. The report mentioned progress, but the emphasis of those participating in the process of overhauling Auditing Standard 2 is going to be the flaws.

It's not quite up there with the pleading e-mails of Barrister Lee Nzugli of Nigeria to help him move $2 million out of his accounts into yours. But it's high on the weird-o-meter, nevertheless.

The Financial Accounting Foundation has posted a notice to the FASB website that "some of its constituents have been contacted by parties falsely claiming to be members of the Financial Accounting Standards Board staff and promoting the sale of certain Sarbanes Oxley compliance materials."

When was the last time a scam artist passed himself or herself off as a member of an accounting standard-setter? Maybe they're becoming more of a part of pop culture. The TV series might be right around the corner!