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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.

The week's big news, regs-wise at least, was the SEC's approval of its "principles-based" interpretive guidance for management of Section 404 - and the PCAOB's subsequent adoption of those principles in its development of Auditing Standard 5. Much of the chatter surrounding the new regs at the SEC's Wednesday meeting focused on the efficiencies to be gained from the slimming down of Section 404 afforded by the changes. You can see it in the remarks of Conrad Hewitt, the SEC's chief accountant: "... we believe that the interpretive guidance for management, when adopted by the Commission will provide for many years in the future a more effective and efficient ICFR evaluation process for existing and future public companies. The guidance will allow companies of all sizes to comply with our rules, while reassuring investors that material weaknesses in internal controls will be brought to light and disclosed." Well, let's hope so. You can also see it in the comments of deputy chief accountant Zoe-Vonna Palmrose: "Overall, these modifications to the proposed guidance are consistent with our objective of rationalizing the planning and conduct of the ICFR evaluation process for all companies, regardless of size, by allowing companies to focus their efforts on those areas that management has identified as posing the greatest risks of material misstatements in the financial statements, not being prevented or detected on a timely basis. This is what investors care about and what's important for achieving reliable financial reporting." All true - this is what investors care about. And it's important. Make no mistake however - there is a tremendous amount riding on these changes to the SOX and auditing literature. While market commentators argue about whether or not the bull market is on its last legs or has years to go, it's doubtful if they'd have much to argue about if the kind of confidence crisis experienced from around 2001 to 2002 had lingered. Reporting-wise, we investors have had charmed lives over the last few years. There haven't been molar-rattling accounting scandals. There have been less concerns about "accounting finesse" in general. There have been multitudinous restatements, but often those have been the result of companies - and their auditors - getting their acts together and doing what should have been done long ago. Investors might have often been inconvenienced by those restatements - but they rarely have had their confidence shattered by them. Cost of Section 404? We hear lots of talk about them, but it doesn't seem to have had much of an effect on the earnings of companies that have actually had to do something about implementing Section 404. The silver lining that seems to have been ignored: maybe once companies took a look at their systems, fixing them might have improved their management information - and maybe companies were managed better. The comments of PCAOB member Charlie Niemeier at the PCAOB's Thursday meeting make a good counterpoint to the cost-cutting victory dancing observed in the wake of the two regs approvals. A few excerpts: "The principal focus of the project to revise our standard on internal control has been to address concerns about costs. What sometimes gets lost, though, is that Sarbanes-Oxley's provisions on internal control reporting and auditing have been resoundingly beneficial to investors. Those benefits have been measured and documented, and they remain uncontroverted. Both companies and their investors have benefited from the reduced cost of capital researchers have measured at companies whose auditors attest that they have cleaned up internal control problems – on the order of a 150 basis point reduction. The investing public has received important warnings that some companies' internal control might not detect or prevent a material misstatement. Perhaps the most spectacular example was Refco's disclosure in connection with it's IPO that it had two significant deficiencies in its internal control. Two months later, the company collapsed due to revelations about related party transactions designed to help it hide losses. Instead of learning about the problems only after the fall, this time investors learned there were risks ahead of time. And we're also seeing unprecedented numbers of companies identify and fix problems in their controls as well as their actual reporting, in most cases before they turn into disasters like Refco . . . and Enron, Worldcom and so many others. Since the first year of internal control reporting and auditing, the percentage of companies reporting material weaknesses has dropped precipitously, from a highpoint of 16.9 percent the first year, to 10.5 percent in the second year. In the third year, as of April 2007 only 5.4 percent of third-year filers had reported material weaknesses. These benefits outweigh the associated costs, by any measure. Moreover there is encouraging evidence, based on corporate proxy reports, that costs have turned out to be less than some had feared and, quite naturally, have decreased since the first year of implementation." As I said - there's a lot riding on these new regulations. Let's hope the charmed lives of investors - at least, reporting-wise - continue to be so pleasant once the regs are in place. * * * * * * * * * * * * Enjoy the Memorial Day weekend. But don't forget why it exists: if not for those who gave their lives in war, you might not be reading this. And I might not be writing it. So, give thanks, please. And I won't be writing...

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As expected, the SEC approved the proposed replacement for Auditing Standard No. 2.

Lots of promises are being made for this standard - scalability (meaning it will be able to be applied effectively by firms of different sizes), cost-effectiveness, and just plain effectiveness. The proof is in the pudding: we'll have to see it in action, or in inaction, over a few years and an economic cycle or two to see just how well-designed it really is. And how well the auditing profession implements it.

According to the press release, the new rules and interpretive guidance will be published 30 days from their publication in the Federal Register. If the finial rules are approved and adopted by the SEC and PCAOB, it's expected to be effective no later than for calendar year 2007 audits.

A couple of big meetings this week in the nation's capitol and they both deal with the same thing: the new auditing standard for evaluating internal control to be known (infamously, perhaps) as "Auditing Standard 5."

On Wednesday, it's Item One on the SEC's agenda at its open meeting. On Thursday, the PCAOB will vote on the adoption of the new auditing standard.

The standard is likely to be significantly more relaxed than the oft-reviled Auditing Standard 2. And adapting to it will likely cause revamping of work to be done in the auditing world, even if it requires them to do less. They'll still have to revamp plans and audit programs - so preparers are likely to still complain that they're not seeing the kind of relief they were hoping for. Whether or not it provokes auditors into getting good insights into the operating mettle of control systems will probably be forgotten. (Until there's a major failure.)

A couple of key resignations at Glass Lewis & Co., the (relatively) new proxy advisory service firm, occurred last week.

First, Jonathan Weil, formerly of the Wall Street Journal and then the managing editor of GL's research department, turned in his keys. Shortly afterwards, research director and former SEC chief accountant Lynn Turner turned his in, too.

Apparently, the two are not happy with the level of disclosures made by GL's new owner, Xinhua Finance, about the activities of the companies CFO at the time of the company's initial public offering. That CFO was Shelly Singhal, who Barron's reports "was fighting a civil racketeering suit in California courts for his investment activities," and before becoming an investor in Xinhua in 2003 had "been a major investor in a couple of companies called AremisSoft and ACLN."

There's a good recap of the events at CFO.com, as reported by Roy Harris. They practiced what they preached: it's good to see that their reputations mattered to this pair.

Last week, the Treasury Department Secretary Henry Paulson unveiled his initiatives for enhancing U.S. capital market competitiveness - most of which are focused on financial reporting and the accounting profession.

Highlights of the plans:
Provide Investors with A Transparent and Sustainable Auditing System. A non-partisan committee to be headed by former SEC chair Arthur Levitt and former chief accountant Don Nicolaisen will "develop recommendations to consider options available to strengthen the industry's financial soundness and its ability to attract and retain qualified personnel."

Hopefully, competition among auditing firms and the accounting education system are considerations.

Gain Better Understanding of Reasons for Increasing Financial Restatements. While the Treasury intends to study why restatements have gone from 116 in 1997 to 1,876 in 2006, this path has already been well-trod by others. Glass Lewis has done a fine job of analyzing restatements over the years.

And the SEC has too. Consider this clip from a speech given by then-deputy chief accountant Scott Taub last November on the subject of errors and restatements: "... disclosures we reviewed that accompanied restatements over the past three years suggest that well over half of the errors that resulted in restatements were caused by ordinary books and records deficiencies or by simple misapplications of the accounting standards.
" [Emphasis added.]

Enhance Financial Reporting
. The Treasury Department supports "SEC and the Financial Accounting Standards Board's efforts to enhance financial reporting transparency and accessibility for investors," citing the 2,000 pronouncements comprising GAAP.

Sounds awful when you hear about "2,000 pronouncements." But not all of them apply to every company.

Streamline Accounting Requirements to Encourage International Companies to List on U.S. Exchanges and Increase Investor Opportunities. The Treasury Department is planting itself squarely behind convergence of international accounting standards.

This is one topic that everyone in the regulatory and government arenas seem to be pushing lately. If it's going to happen, it'll need that kind of push.

From Ira C:

Mr. Ciesielksi –

Maybe I'm a bit sensitive here, but you noted the accounting issue brewing at International Rectifier was an “interesting case developing in Silicon Valley”. International Rectifier is located in El Segundo, California (which is near Los Angeles) and audited by the Los Angeles office of PricewaterhouseCoopers. Silicon Valley is typically associated with the San Francisco Bay Area and given that El Segundo is about 350 miles south of Silicon Valley, I'm not certain I understand the connection to the “interesting case developing in Silicon Valley”.

You are perfectly correct.

It was a result of my habit of associating all things tech with Silicon Valley, and I think of semiconductors as tech-y.

I have since revised the post to include the more geographically diverse name, "Tech-Land."

And that's "Ciesielski," not "Ciesielksi." Thanks for writing in!

Tyco International, the company that made shower curtains an element of corporate intrigue, will settle class-action investor suits for almost $3 billion, as reported in the New York Times and International Herald Tribune. At this stage, it's unclear what shareholders will clear: there are still millions to pursue from the principal characters like Dennis Kozlowski and Mark Swartz. Bigger variable: the lawyers' cut is not known yet, either.

The Wall Street Journal reports that this could be the fourth largest shareholder settlement ever. And investors might be able to pursue auditor PricewaterhouseCoopers on the grounds that they should have detected the fraud. PwC was not part of the settlement, so it could still be open season on them.

The PCAOB adds a new position: Director of the Office of External Relations, which is itself a new unit. It will be headed by Mary Moore Hamrick, who was previously the PCAOB's Director of Governmental Relations.

The new Office of External Relations' goal is to inform and obtain "feedback from investors, auditors, policymakers and other interested parties about PCAOB activities."

Should be interesting to see what degree each of those interested parties participate in providing feedback.

Leaving the PCAOB is Phil Wedemeyer, who has been the PCAOB's Director of the Office of Research and Analysis. (That's the part of the PCAOB that divines audit risks and communicates them to the PCAOB-registered audit firms; sort of a auditing think tank.) He'll be replaced by Martin Baumann, a former CFO of Freddie Mac during the financial restatement period and a 33-year PricewaterhouseCoopers veteran.

Another SAB 108 housekeeping cleanup dealing with options, this one from Cognos' 2007 10-K.

Cognos went the beginning-of-year retained earnings adjustment route to clean up two errors. The first dealt with stock option practices. Like Bed Bath & Beyond, the firm hadn't discovered its option practice problems until the current year and therefore, could not have applied either the rollover method or iron curtain method all along the years of improper practice. SAB 108 calls for the proper application of just one of them over time if the beginning-year adjustment treatment is to be earned. Cognos did evaluate the problems as far back as 1996 - but it didn't evaluate them until the current year. All told, it amounted to about a $4 million adjustment.

Cognos also had a revenue issue, not too dissimilar from what had been noted at Apria Healthcare and Lincare Holdings. These firms had basically recognized revenue in full for the month in which they billed a customer, rather than starting the revenue clock running from the date of billing. Cognos was following the same principle in their support service area; upon correcting it, the deferred revenues were pumped by almost $8 million. The net after-tax effect was about $6 million.

Nothing stunning about the size of the corrections, though one might disagree with the finessing of the retained earnings stock option treatment. (From the 10-K, it did sound like the firm was aware of the "off-ness" of the revenues all along since 2003.) What's curious is the sort of mini-pattern (or just coincidence) emerging in the area of revenues and stock options: looks like firms are only too willing to bury stock option issues as soon as they find them. And it looks like revenue imprecision related to the timing of billing is rather common.

Interesting case developing in Tech-Land... one that doesn't even include options backdating.

Semiconductor manufacturer International Rectifier gave a heads-up to investors in early April that all was not right with its financials for the year ended June 30, 2006 and various quarterly periods. At the time of their announcement, the company was still in the preliminary stages of their investigation and really didn't offer much in the way of describing what was wrong with the financials.

Now they've fleshed things out a bit, and filed another non-reliance 8-K with more details. What happened?

A foreign subsidiary had, "from time to time," entered unrequested orders from customers into the revenue system. That "resulted in the shipment of products and the recording of sales with no obligation by customers to receive and pay for the products. The practice included routing certain product shipments to warehouses not on the Company's logistical systems."

You could consider that a pretty serious lack of internal controls; so does IR's audit committee. Interestingly, the 8-K notes that "a significant increase in the reported sales by that subsidiary during the quarters ended March 31, 2005 and June 30, 2005 may have resulted from the practice described above." That sounds like someone was very concerned about meeting targets and felt compelled to be creative.

No word yet from the company on the extent of how the improper "sales" affected revenues, receivables and inventory; all things in due time, one supposes. The company may have missed the forest for the trees in completing its internal control review at the end of 2006; no mention of the foreign situation in its internal control report - and no contradiction of their assessment by their auditors, either.

* * * * * * * * * * *

One backdating-related bleat for the day: Dean Foods mentioned in its 10-Q that it had been notified by the SEC that the informal investigation into its option practices had ended with no recommended enforcement action. This is just after the same kind of disclosure by Nabors Industries. Is this what the end of the options backdating investigations looks like?