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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.

Over the last few months, I've mentioned the SEC's proposal to eliminate the reconciliation of "pure" IFRS earnings and stockholders' equity amounts to their US GAAP equivalent in SEC filings.

I've also mentioned the response of the Investors Technical Advisory Committee, which got a little airplay in the New York Times yesterday.

I've drafted a letter of my own, and submitted it to the SEC on Monday. Same sentiment as the ITAC letter, with a few more examples, drawn from the report on the two SEC international proposals that I issued on Monday.

Sign up for the free two-issue trial, and you'll receive the report on the two proposals - an issue that's going to roil investors for years to come, I think. As always, this offer is restricted to institutional investors only, with inclusion in the BigDough investor database as a litmus test for determining who are "institutional investors."

There’s a good post by Edith Orenstein over at the FEI Financial Reporting Blog, covering the current events surrounding securitizations and the accounting for them. Like it or not (mostly not), there are politics aplenty ahead in the reporting for these financial Pandora’s boxes.

As reported in the Wall Street Journal ($), a 10-state task force of attorneys general and banking regulators has been formed. Their purpose: “to persuade mortgage-servicing companies and investors in mortgage-backed securities to increase the number of troubled subprime loans they restructure.” A position paper has been issued by the group, and it contains some real nuggets about the nature of securitizations and how they have contributed to the foreclosure wave. Like this one:

“Securitization has played a central role in lenders placing borrowers in unaffordable loans because it has separated the origination of a loan from its consequences. It is often repeated that no rational lender would put a borrower in a loan that the borrower cannot afford. That may well have been true in the past, when most loans were made by portfolio lenders, but is not true in today’s complicated and fractured system. While no investor would want to buy a loan that is destined to fail, many players in the current mortgage system were all too happy to originate loans without regard to the borrower’s ability to repay because when it comes time to foreclose on a loan, the originator often is long removed from the picture and does not take the loss. Thus, originators have engaged in predatory practices that a portfolio lender would never engage in, such as inflating an appraisal or inventing borrower income, because the originator can sell the loan to the secondary market...

In short, the secondary market dramatically changed the incentives for originators. Many subprime originators are no longer concerned with the terms of the loan or whether the borrower ultimately is able to afford the loan. Instead, the originators’ incentive is to close the loan as quickly as possible, no matter what, in order to be paid their origination fees, and then sell the loan to the secondary market.”

The group’s recommendation: restructure loans early and often. Pay the servicers a fee for modifications. Hire more staff with resources to actually make modifications. Forge alliances with third parties with whom borrowers are willing to work. (50% of defaulting borrowers never talk to the servicer.) The recommendations are pretty much basic common sense: do what it takes to avert problems, do it well and charge a fair price for doing it.

Nowhere did they say that the accounting shouldn’t reflect what happened - but that’s apparently not what others believe. It was noted in this space a couple weeks ago that Senator Charles Schumer was encouraging the Big Four that they should lighten up on the financial reporting of lenders who give it up for defaulting borrowers; on the letter, he also copied Cynthia Fornelli, head of the AICPA's Center for Audit Quality, just to be sure that the good news got spread even more widely. Schumer asserted that the SEC Chairman Christopher Cox "unequivocally" stated that the SEC's position on loan modifications in advance of defaults was benign and that lenders needn’t worry about losing off balance sheet status for securitizations. Frankly, the discussion by the SEC seemed more fact-and-circumstances than “unequivocal.”

If securitization issuers make modifications to loans, don’t put the obligations back on the balance sheets and don’t provide any other disclosures, it’ll make for some puzzling results later if they’re recognizing fees for reworking loans. In fact, if firms don’t discuss their activities involving renegotiations but account for them as if nothing happened, there’s going to be some very close parsing of every sentence uttered by managers of financial institutions.

The Investors Technical Advisory Committee is an advisory group composed of a dozen individuals who are associated with the investment world, usually by employment. What they share in their backgrounds is that they have some decent accounting chops.

The twelve of us have put together a comment letter to the SEC on their proposal to eliminate the IFRS-to-GAAP reconciliation requirement for foreign filers who report on a pure IFRS basis. ("Pure IFRS" means that the financials are prepared in accordance with the International Financial Reporting Standards as published by the International Accounting Standards Board. Any "country-flavored" versions of IFRS - where IFRS have been adopted with exceptions to particular standards - don't qualify for the reconciliation waiver.)

When confronted with the question of whether or not the reconciliation should continue, I think the knee-jerk reflex of many investors is that it should be trashed. There are two things wrong with this (aside from being a knee-jerk reflex in the first place):

  • As a matter of course, investors might not go to that reconciliation and immediately make a buy-sell-hold decision based on what they see in it. For those who actually read financial statements and try to understand the workings of a foreign company in the context of something they're already familiar (US GAAP), that reconciliation provides a useful environment.

  • "Then what?" Those are two of the most under-rated words in the investment world. Eliminate the reconciliation and crow that you've "simplified" the system. Then what? Will convergence of accounting standards still take place the way it should? Is there still a reason for standard setters to work together on problems if there's no visible display of what makes their results different?
In writing this letter, we asked ourselves "then what?" many times - and I think we've come up with some issues that go beyond merely looking like something has been accomplished by eliminating this reconciliation. I hope you'll take a look at it and think about the issues we've raised - and write your own letter. It would be a complete embarrassment to the US financial reporting regime to see this reconciliation be yanked - only to see it return years later once it becomes apparent that it was too early to do away with it.

Starting today, I'll be abandoning the old WordPress-style blog that's hardly changed since inception almost three years ago. This new platform is a bit more flexible in terms of things I'd like to do with the blog, and the Accounting Observer website as well. I think you'll get over the initial shock and it will come to grow on you. (I hope so, anyway.)

Another change: I'll be blogging exclusively for subscribers to The Analyst's Accounting Observer. Paid subscribers will see all posts going forward, same as always. Guests to the blog will still have access to all past posts, but I'll only be putting selected posts in the public domain from now on.

Why the change? Simple, really. Not only has the blog taken a lot of time, there are some avenues I'd like to explore as I write it; I have some ideas for making it more "data-rich" at times, or more research-intensive. I'd like to make those things happen for the subscribers to the Accounting Observer service, rather than give it away for free. Yes, that's a shameful plug for you to subscribe to The Analyst's Accounting Observer. I hope you do; trial subscription link here.

An interesting piece by Sarah Johnson in CFO.com: if the SEC’s idea for removing the reconciliation between US GAAP and IFRS-presented financials becomes a reality, then there could be unexpected fallout for companies in the tech sector. The revenue of tech companies following US GAAP might look like it’s growing more slowly than companies following IASB standards.

If two companies have the same identical contract kind of contract, containing elements with different deliverable dates, the one following US GAAP will recognize revenue only as the components are delivered. The one following IFRS would be able to estimate the fair value of the yet-to-be delivered items and recognize the revenue up front. (That’s not too far afield from “gain-on-sale” accounting, which nobody seems to really like - once it stops working, anyway.)

Might be a case of the law of unintended consequences at work: maybe that helps pave the way to success for the SEC’s other international project, which is the concept release proposing that domestic firms get a choice between reporting in US GAAP or IFRS.

At any rate: enjoy the long holiday weekend! See you on Monday

Yesterday’s FASB meeting saw pension and OPEB standards creep back into a higher priority category than they’ve been for a while. Last year saw the the issuance of Statement 158, which put net benefit plan balances onto firm balance sheets; since then, there’s been hardly a peep about Phase 2 of the revamp of the benefit plan accounting standards.

The FASB staff proposed action on five areas (meeting handout here):

• Earnings smoothing (the expected return on assets mechanism and delayed recognition of events like market losses)

• Recognizing a single unit of cost (instead of the current stew service & interest costs, plus various amortizations and expected returns)

• Measurement of benefit obligations

• Disclosures (some would like more; others less. The staff’s proposal was that the Board should work the current derivatives disclosure project into this project)

• Getting some accounting standards - or at least disclosures requirements - worked into the accounting literature for multiemployer plans. (Currently, there’s not much accounting done for these.)

The Board seemed to agree that the issues were the right issues. Expect that they’ll keep a close watch on the IASB’s similar project which is a bit further along, and attempt to borrow what they can in an effort to keep things moving and to maintain the convergence process.

A couple days ago, it was noted in this space that Vail Resorts had some large changes in its cash from operations after putting its cash flows from its real estate operations into the right bucket of the cash flow statement.

Just a couple days later, a similar reclassification shows in the non-reliance 8-K and amended 10-Q of BCSB Bankcorp, a tiny bank in my hometown of Baltimore. (Also famous for its record-breaking baseball team.)

It seems that BCSB had classified the proceeds from the sale of loans as an operating item, when in fact they should have been properly classified as an investing inflow. It wasn’t insignificant: taking the $45.2 million of cash inflows dropped the nine-month cash from operations from $50.4 million down to $5.2 million - a 90% decrease.

It’s a good reminder: the cash from operations figure is probably the single most-viewed number on the cash flow statement - and many times analysts and investors look at it as the unvarnished truth, in comparison to net income. Not always the case, and preparer mistakes like these are one reason investors shouldn’t get overly comfortable with just one way of looking at performance in trying to understand what’s going on in a company.

The politicians are piling on the accountants.

About a month ago, Representative Barney Frank asked the SEC to look into loosening up sale criteria in Statement 140 so that lenders might be less nervous about renegotiating toxic loans. The culmination of his request: it's not managing a qualified special purpose entity if you're sure that it's going to go bust anyway. Don't worry about wrecking any sale treatment you might have reported beforehand.

Now Senator Chuck Schumer is getting in on the act. According to CFO.com, he's sent a letter to the CEOs of the Big Four auditing firms, encouraging them to do their part to resolve the subprime crisis by making sure their clients know about the new, improved interpretation of Statement 140 and encouraging them to work with their clients so that they keep housing markets afloat.

Maybe my memory is too long - but didn't we have a long period of self-flagellation over whether or not auditors were supposed to be independent of their clients, not very long ago? Here, we have a United States senator asking the audit profession to be a stimulus of the economy. What does the government want from the auditing profession - independent verification of financial reporting to instill investor confidence in markets? Or does it want them to shill for political policies because they happen to be situated at a convenient nexus in the financial reporting machinery? Let's hope its not the latter.

Interesting cash flow statement restatement from Vail Resorts filed on Friday.

The company has a real estate segment whose activities "include the planning, oversight, marketing, infrastructure improvement and development of the Company's real property holdings. In addition to the substantial cash flow generated from real estate sales, these development activities benefit the Company's mountain and lodging operations through (1) the creation of additional resort lodging which is available to guests, (2) the ability to control the architectural themes of the Company's resorts, (3) the creation of unique facilities and venues (primarily restaurant, retail and private club operations) which provide the Company with the opportunity to create new sources of recurring revenue and (4) the expansion of the Company's property management and commercial leasing operations..." according to the latest Vail Resorts 10-K.

That description sounds like a pretty active operation - something that's a day-to-day veritable beehive of real estate happenings. Yet the company had accounted for its real estate segment activities within the investing section of the cash flow statement instead of the operating section. Big difference: when restated, operating cash flows for year end (July) 2006 were 67% lower; for 2005, 33% lower; and for 2004, 15% lower. With real estate transactions requiring big lumps of investment over long periods of time, resulting in big gushing inflows later, you'd expect that the new presentation will show cash from operations in truer, spikier fashion.

The cash flow statement remains a source of restatement issues. Stay tuned.

Whoa. Will post about accounting matters later, but I need to get my head on straighter, first. Hard to focus on fair value issues or auditors or restatements when you've spent the evening before at the all-girls roller derby...

My sister-in-law coaxed me and my wife to attend the Charm City Roller Girls Sunday night match between the Night Terrors and the Junkyard Dolls and the match-up of the Speed Regime and the Mobtown Mods.

All action and theater. And '80's music wailing in the background at the Putty Hill Skateland. Gals on skates with names like Siouxsie Slaughter, Deathany, Snatch Bunny, Roxy Toxic, Flo Shizzle and my favorite ... Frenzy Lohan.

Fun stuff. I got Flo Shizzle's autograph! She was the best sprinter there; pretty incredible. More fun to watch than I expected!

Back later.