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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.

Today is the official last day at work for Chester Spatt, the SEC's Chief Economist, as mentioned last week.

His successor was named last Thursday, and he show up for work next Monday. He's Dr. James A. Overdahl, and he hails from a similar post at the Commodity Futures Trading Commission. The press release describes him as "...a specialist in financial derivatives, [who] is returning to the SEC, where he served as a Senior Financial Economist in the Office of Economic Analysis from 1989 to 1992."


"Dr. Overdahl is the co-author of several leading financial books in multiple editions, including "Financial Derivatives," "Futures, Options, and Swaps," and "Understanding Futures Markets." He has written extensively on derivatives, trading practices, options, stock exchange regulation, and enforcement related issues, including in the Journal of Law and Economics, The Business Lawyer, the Journal of Derivatives, and the Journal of Financial and Quantitative Analysis."

Judging by his skill set, it sounds like the SEC is expecting this area to be a hotbed over the next few years.

Failed shortcut accounting (in testing for "effectiveness" of hedge relationships) has provided frequent fodder for this blog.

Last week, the FASB issued a proposal that might get financial statement preparers on the right track in their pursuit of simplicity. (And manufactured effectiveness.) It's "Statement 133 Implementation Issue No. E23" and you can see it here.

Comments due September 21.

About a month ago, House Financial Services Committee Chairman Barney Frank sent a letter to SEC Chairman Christopher Cox asking for clarification on whether renegotiation of subprime loan terms (before default) would spoil a "sale treatment" on a securitization. The concern is that perhaps lenders have been a bit starchy about helping out borrowers who have turned out to be subprime repayers. The lenders may have been afraid of having too much involvement, beyond the typical servicing of loans, with a supposedly "autopilot" securitization trust - and perhaps having to undo the sale of the loans. That would put assets and obligations back on their balance sheet.

On Tuesday, the SEC responded to Representative Frank: no problem. Based on the SEC's request, the FASB held an educational forum on June 22 with about 30 participants. As a result of the forum, the SEC concluded: "There was general agreement among participants at the FASB educational forum that, subject to certain constraints, the ability to restructure mortgages when default is reasonably foreseeable is an activity that is not inconsistent with the notion of continued off-balance sheet accounting treatment...[W]orking out a loan where default is reasonably foreseeable is similar to the discretion required when a loan becomes delinquent or default has occurred. When a loan is delinquent or when default has occurred, FAS 140 implementation guidance provides that a servicer may have discretion in restructuring or working out a loan, subject to certain limitations, without calling into question off-balance sheet treatment for the loan.

Currently, the Commission's staff does not believe that additional interpretive guidance is necessary in order to clarify the application of FAS 140 to the contemplated types of securitized mortgage loan work-out activities..."

So far, everyone gets what they wanted. Barney Frank gets the exemption he sought. Borrowers might get more slack from lenders who won't be afraid of jeopardizing their sale accounting treatment. The SEC doesn't have to issue any more prescriptive interpretation than this, and the FASB doesn't add anything to its agenda. In deferring to clients on securitization conflicts, auditors can point to Conrad Hewitt's memo as a guideline for not pushing for re-recognition of assets and obligations.

Hey - is this principles-based accounting great or what?

Are investors worse off because of this decision? Maybe. If you take the strict view that these things never should be accounted for as sales, you'll be unhappy any time sales treatments are preserved. But there is also justification for the view that servicers of the securitizations can have some latitude in working out these arrangements - the question is how much of that latitude gets back into really managing the assets once again, and that's something of a facts-and-circumstances kind of judgment to make.

Where the damage might really be done to investors: if there are no consistent consequences for accounting with mediocre accountability (contorting the idea of "ongoing activity" to fit into a pattern that won't ruin sale treatment), then there's no incentive for issuers to stop making loans to poor credits that they package into securities, fob off on someone else, and not have to re-recognize when the underlying loans meet the wall. Weak accounting reinforces weak lending behavior.

Renegotiating the already-bad loans out there might just be like the little Dutch boy plugging the leaky dike with his finger. It's not likely that it will end the subprime problems. So why keep up the facade in the accounting?

But you can get a free accounting degree, it seems. For real.

The Australian reports that "there are four vacancies for every one accountant and the shortage is expected to get worse because not enough school-leavers are choosing to study the field. Universities and accounting professional bodies are running advertising campaigns to make accountancy more appealing to students by changing perceptions that it is just number crunching."

In response, high school seniors (Year 12 students, down under) "are being offered part-time jobs and free university degrees by firms, even before they have applied for a university place." Wonder if those free educations could happen here?

The SEC announced yesterday that it intends to seek comments from US investors on allowing US companies to report in either US GAAP or IFRS accounting standards. There'll be a 90 day comment period once the proposal is released in the Federal Register. (It's not out yet; I'll link when it's available.)

This is on the heels of the Commission's proposal to eliminate the reconciliation between the IFRS reporting and GAAP in filings of foreign registrants. Funny - if you look at the "convergence roadmap" laid out by former chief accountant Don Nicolaisen, the staff was expected to decide "whether and when it is in a position to recommend to the Commission that it eliminate the IFRSs to US GAAP reconciliation requirement" in "2009, or possibly sooner." Sooner it is, it seems. All those reviews of IFRS-to-GAAP reconciliations that were to take place in 2006 and 2007 must have revealed that everything is working just fine in IFRS-land...

The discovery period of the backdating drama is largely behind us - it seems like all the special committees that were formed last year to examine suspicious awards have finished their work and cleansed corporate consciences.

Now we're in the prosecution phase, where most of the activity is going to be initiated by the SEC. The agency's machinery has been clicking along a bit faster lately, and yesterday the Commission announced that it was filing backdating-related charges against semiconductor company KLA-Tencor and its former CEO Kenneth Schroeder.

The routine backdating schemes overstated KLA-Tencor's net income in fiscal years 1998 through 2005 by as much as 156 percent.

The company settled with the SEC by "consenting to a permanent injunction against violations of the reporting, books and records, and internal controls provisions of federal securities laws;" it wasn't charged with fraud, and no monetary penalty was sought by the Commission because of the company's cooperation in the Commission's investigation and its extensive remedial measures. Kudos to the firm for staving off SEC action that would have caused the current shareholders to suffer any monetary damages.

The former CEO on the other hand, has still got the worst ahead of him. The Commission charges that "he repeatedly engaged in backdating after becoming CEO in 1999, including pricing large awards of options to himself that were "in the money" by millions of dollars - a potential windfall never disclosed to KLA-Tencor's shareholders. According to the complaint, Schroeder received a legal memorandum in March 2001 cautioning that "the Board and its committees are limited in their ability to grant options at a retroactive price without exposing the company to risk of an accounting charge." The memo further warned that "[a]ny attempt to set a price before such a grant is made raises substantial risks under securities and tax laws [and] accounting rules and gives rise to disclosure obligations." The Commission alleges that Schroeder nonetheless continued to backdate options."

Sounds like backdating options is just like eating salted peanuts - who can eat just one?

Yesterday the SEC approved the PCAOB's Auditing Standard 5 - the replacement for the much-maligned Auditing Standard 2. Press release here.

The expected promises of AS 5: it'll provide for "scalable audits" that are less prescriptive and employ more auditor judgment about the necessity of the extent of testing. (Not that AS 2 didn't allow these audit traits.) It'll make for more efficient and less costly audits. We'll have to wait and see how effective such efficient audits will be under this new auditing model. One thing for certain: there's absolutely no excuse to absolve small firms from internal control examinations any longer. (Not that there ever was a good reason to do that.)

Early this year, many companies took advantage of their options - their fair value options, that is - and adopted Statement 159 as of the beginning of the year. That recent standard lets companies apply fair value accounting to many balance sheet items that have been reported at historical cost or some variation thereof.

Some companies chose to game the standard, skeevily: they'd flush losses in their held-to-maturity or available-for-sale portfolios through retained earnings by the implementation process. Then they'd replace those portfolio securities with the same kind and go back to using historical cost accounting for them.

(Subscribers to The Analyst's Accounting Observer: see Volume 16, No. 7, dated June 13, for more details and names.)

Some companies had second thoughts about the legitimacy of such an approach after SEC Deputy Chief Accountant James Kroeker warned that the Commission might challenge such treatments - and a number of companies changed their minds. (Again: complete list of the recanters is in The Analyst's Accounting Observer, Volume 16, No. 7, dated June 13.)

Last week, another company changed its mind: Cadence Financial issued a non-reliance 8-K last week indicating it was pulling its first quarter 2007 10-Q and earnings release on the grounds that it was rescinding its fair value treatment of "a securities transaction involving fixed rate collateralized mortgage obligations (CMOs) and adjustable rate mortgage-backed securities." The revised 10-Q should be out today.

Last week, the SEC announced that its Chief Economist and Director of the Office of Economic Analysis, Chester Spatt, will be leaving the Commission at the end of July. He plans to return to academia: he'll be teaching at Carnegie-Mellon University in Pittsburgh.

Anyone who thinks that "economics is boring" should take a look at some of the controversial topics Prof. Spatt and his office have had to tackle during his tenure. There was the failed option-expense plan of Cisco; rising controversy over executive pay, including options; the ESOARs product devised by Zions Bank; and the rising importance of fair value modeling in financial reporting. The Commission hasn't yet announced his successor - but it would likely be someone with the same background and strengths, because those issues addressed by the professor and his staff haven't diminished in complexity or sensitivity.

I mentioned it as an aside about a month ago: the SEC built a web-based tool to let investors find the companies that do business with countries that the State Department has designated as sponsors of terrorism.

It didn't strike me as the kind of thing all investors would want: there as many varieties of investors as there are companies. It seemed like an admirable tweak of the EDGAR system however, a subtle one that would increase value to many investors without a lot of effort. There are some investors that do not want their portfolios to provide any possible financing to sponsors of terrorism (the State of Florida's pension system, for one example). This was a good "first cut" kind of tool for many of them. And there are many "little guys" who would like to do the same.

So, it didn't seem like it was something destined to raise much dust when it first arrived. Then last week, Barney Frank, chairman of the House Committee on Financial Services, criticized the tool as being inaccurate.

On Friday, the SEC took the tool away from investors. According to a statement by Chairman Christopher Cox, it will return with more up-to-date information. That carries the implication that the tool will corral information from 10-Qs as well as 10-Ks. (The original tool extracted data from only 10-Ks.) Cox also hinted that the tool might evolve into an XBRL project - and that "the Commission staff will also consider whether to recommend a Concept Release on the question of how best to make public company disclosure of activities in terrorist states more accessible. The release would solicit public comment in a formal way, so that the Commission could ensure that all legitimate concerns can be met while providing better access to company disclosures on these topics." If that happens, it will be quite a while before tool reappears - and it'll be interesting to follow the dialogue on the concept release. Those firms who try to stonewall it will be visible in the process, and their motives for slowing down the development of the tool would be justifiably questionable.