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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.

EITF meeting today - not much time to write, but a couple of things for you to consider that you might not have noticed.

First, an excellent description of the above-named securities in a speech by Erik Sirri , the SEC's director of the Division of Trading and Markets. Erik explains the "concentration-despite-diversification" present in these creations, how they dissolved, and makes a couple of not so bold predictions, which are probably dead right. Like this one:

"I'm enough of a historian to know that, some number of years down the road, we or our successors likely will again be commenting on why some other product or business led to large and unexpected losses. But it will probably not be super senior ABS CDO."

Anyway, it's a good read, with more technical description of what goes on in making these things - and their markets - than you'll read in the mainstream financial press.

And there's also a very British view of the way these things work, courtesy of YouTube.




Stiff upper lip, and all that. This one has been making the rounds: I first spotted it in TheCorporateCounsel.net blog , who had gotten it from Kevin LaCroix. And I've received it from friends by e-mail too. Enjoy.

Yes, we've already had Black Friday, and today is Cyber Monday. No doubt you'll be on the receiving end of gift cards purchased sometime in the holiday shopping season, and you'll probably give a few of them, too.

There's an accounting angle to those gift cards: they're not sales for the retailers or restaurants that issue them until they're redeemed. Until the ultimate customer purchases something with them, they're just deferred revenues sitting on the right-hand side of the balance sheet. And if they never get redeemed by the giftees, they simply sit there: a lump of liability, coal in the stocking of the balance sheet.

That non-redemption can be very common. (How many of those cards do you have sitting in a desk drawer from last Christmas?)

The liabilities can be removed via journal entry, courtesy of the concept of "breakage" - meaning that the liabilities get de-recognized when management determines that a portion of the gift cards will never be cashed in. The SEC weighed in on this a few years ago when it issued SAB 101 , which ultimately became SAB 104 . Bottom line: it's not improper to de-recognize, as long as it's supportable. And from the investor point of view, the timing of any de-recognition would be noteworthy: any clean-up of the liabilities in a weak quarter might be suspicious, perhaps motivated by a desire to meet estimates.

There's no particularly noteworthy case of a company using gift card breakage to manage earnings. Maybe it's been done, but the disclosures might not be sufficient to leave a bread crumb trail. CFO.com has a good story on the concerns surrounding gift card accounting, and the Journal of Accountancy has an interesting article and study on their prevalence by Charles Owen Kile Jr., an accounting professor at Middle Tennessee State University.

Apparently gift cards aren't the only thing that recipients forget about. Here's a link to a story about something probably more valuable that people forget about as well: income tax refunds. That one is more amazing: if you bothered to send in a tax return, wouldn't you be looking forward to getting some cash back? Apparently not: the IRS says there's $110 million in unclaimed refunds outstanding.

Yesterday, the FASB voted to propose a deferral of Statement 157 - not the full Monty, but a portion of it. The part of Statement 157 that applies to financial instruments - the spaghetti hitting the fan these days - will not be deferred. So come next year, investors will still be able to pore over filings, trying to gauge their tolerance of Level 3 valuations of collateralized debt obligations and the like. The part of Statement 157 that will be deferred for one year - presuming the proposed staff position will be favored by constituents (a process not unlike asking a bear if it likes meat) - is its application to all nonfinancial assets and nonfinancial liabilities, except for those items that are recognized or disclosed at fair value in the financial statements on a recurring basis. Some examples: non-financial assets and non-financial liabilities that are measured at fair value in a business combination; indefinite-lived intangible assets; asset groups in impairment tests; and asset retirement obligations initially measured at fair value. No deferral on derivatives – financial and nonfinancial ; servicing assets and liabilities measured at fair value on a recurring basis under Statement 156; loans; and debt. So investors can relax a little bit - the scary stuff of the moment will still be uncovered by Statement 157. (Hopefully.) One has to wonder what the deferral really accomplishes: the items on which 157's applicability is deferred are mainly the things of acquisitions and impairments. The (eternally) forthcoming standard on business combinations, Statement 141R, is expected to address these issues, and sounds as if it won't be effective until 2009 - just like this deferral. Is this just your regular double-strength, double-secret deferral? Or is the arrival date of 141R even later once again? Or is it good public relations so that the FASB appears to be receptive to the requests of preparers who have coughed up concerns about Statement 157 late in the game? Maybe all three. Insufficient data to evaluate, for now. One note: in the FASB's handout materials for the meeting, they mention that "Preparers that advocate a deferral note that the early adopters had been following the deliberations of the Statement more thoroughly and extensively than those that did not early adopt. They also observe that the early adopters are primarily large financial institutions that have significantly more experience and dedicated resources in valuing financial instruments (as well as nonfinancial instruments). Not so fast. In connection with an upcoming piece on fair value reporting, we've tracked down 88 publicly-traded firms that adopted Statement 157. They were definitely not "primarily large financial institutions that have significantly more experience and dedicated resources in valuing financial instruments." (Although they were mostly financial institutions.) Of the 88 firms, 56 of them - over 60% - had a market capitalization of less than a billion dollars. The median market cap: under $300 million. Check the chart at left: of the ones we found, the vast majority were in the lowest market-cap decile. (Deciles measured in billions.) So let's not assume that all of the 157 early adopters are the now-stumbling financial giants; there were quite a few tiny community banks in the group. 



 Statement 157 is often blamed for asset writedowns in the colossal financials, amid whining about "Level 3" valuations - as if they're something new. Statement 157 didn't cause  the problems - it's making the problems (crummy lending practices) visible, and opening up dialogue on handling them. Critics worry that the giants have diddled here and there with "mark-to-model" valuations and blame Statement 157 for allowing this to happen. The truth is that the standard had nothing to do with that - the diddling possibility always existed. The irony is while the big firms got the blame, the small firms were the ones actively gaming the standard, in conjunction with the fair value option, earlier this year. Remember when many small banks were trying to flush their losses on impaired held-to-maturity assets through retained earnings? That was genuine standard gamesmanship, but it's largely forgotten now. We'll be examining more of the myths and misconceptions about fair value reporting in the next report. Coming to your inbox soon, I hope.  If your firm doesn't subscribe to our research, maybe this would be a good time to start.


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That ol' "Singin' Sage of Wall Street" is at it again.

Last summer I introduced you to Merle Hazard, that extraordinary country singer whom you won't remember, but you've heard before. Shoot, you've heard songs about losin', takin' that lonesome train to a jail in a far-off county, with his wife slippin' around while he was in the pokey, and then becomin' a hedge fund manager when he got out. Yeah, you've heard those songs. They were all Merle, in case you didn't catch the name.

Merle's back! He's got a new video that's absolutely surreal. It's been years since I saw Arthur Laffer in a country music video, and he's as witty as ever in this one. And I haven't heard a good re-mix of a Mac Davis song, since... well, since the last time I saw Arthur Laffer in a country music video. Click here to watch Merle's latest.

And click here to see Merle's very own brand new website. Learn about the man behind the music! Score Merle merchandise! Uh, wait a minute - that part of the website's not ready yet...

Thanks to buddy Jon Shayne for letting me know Merle's back! Y'know, I still say they look a lot alike...

The move to international accounting standards will pick up more steam this week. As mentioned last week, the SEC will vote on Thursday as to whether foreign registrants will be permitted to ditch the IFRS-to-GAAP reconciliation in their SEC filings. The guess here is that they'll go for for it: gone for good, effective with 2007 filings. As I said in my comment letter , convergence is not a bad idea at all. It's just a question of execution. There are many, many differences to be worked out, and not just in the standards. There are differences in the way the standards are developed, the independence of the standard setters, and the auditing and enforcement mechanisms. Getting to convergence is a monolithic task, and the reconciliation has been a good lever for keeping pressure on the standard setters on both sides of the Atlantic. On Thursday, I believe the lever will be shattered. From there, it gets worse: on to the SEC's Concept Release proposal for US firms to be allowed to have a choice of reporting in IFRS or US GAAP. The FASB's Investors Technical Advisory Committee drafted a letter that pretty much captures my concerns about the idea. (I didn't write a separate one.) The Financial Accounting Foundation and the FASB jointly responded to the concept release, and they pretty much threw their weight behind the SEC's proposal. The sharpest point they made related to the dropping of the reconciliation; they recognize that this is the only push needed to get the IFRS snowball rolling down the hill: "... The removal of the requirement that foreign private issuers reconcile their reported results to U.S. GAAP is a difficult and sensitive issue that could have important implications for the continued development of a truly international financial reporting system. We suggest the timing of any removal of this requirement should coincide with the following: • Development of and commitment to the blueprint by key parties in the U.S.; and • Commitment by key international parties to undertake the steps necessary to strengthen and sustain the IASB as the independent body responsible for establishing high-quality international standards. We strongly agree with the SEC that the reconciliation requirement would be removed only for companies applying IFRS as adopted by the IASB. Good point, but one made too gently. Development of that blueprint can't be done overnight; it's an enormous task in itself, with plenty of buy-in needed from all parties and plenty of political elbow grease. It's doubtful that the SEC will want to wait long to waive the reconciliation. The FAF/FASB letter outlined the steps needed to make the transition work, and their letter does a great job of making you realize just how big a task it will be - and how much confidence is at stake if it doesn't work. While they call for a detailed blueprint, containing real dates for milestone achievements, the existing standard setters seem vaguely unconcerned about their future involvement. Indeed, they view their future role this way: We believe that the blueprint should identify the future role(s) of the FASB after U.S. public companies transition to IFRS. Some of the alternatives are listed here. • Like other jurisdictions, the U.S. might retain its standard-setting body to develop standards for private companies, not-for-profit entities, or other organizations that use U.S. GAAP but do not participate in the global capital market. • The FASB might have a role in educating U.S. constituents in the application of IFRS or in identifying U.S. issues as candidates for IASB action. • The IASB may see value in establishing regional affiliations to improve liaison with constituents outside Europe. The FASB might be able to fulfill that type of role. That's a view pretty far down the food chain for the world's once-premier accounting standard setter to imagine itself. It's not a stretch to compare it to what happened to the AICPA once the FASB was designated as the sole standard-setting authority by the SEC, as authorized by the Sarbanes-Oxley Act. The AICPA, no longer able to set standards for US publicly-traded companies, flirted with setting standards for private companies. Looks like FASB is thinking about the same thing. And again, it's driven by the SEC's choices.


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Huron Consulting Group, built by ex-Arthur Andersen partners, has studied restatements over the years. They've put together a "best practices" document that's sure to be in demand among companies that might be 'fessing up to past errors. You can download a copy of it here. (Registration required.)

Investors might not be particularly interested in best practices for going through a restatement process: "just the facts, ma'am" is more or less all they care about. Nevertheless, there are some interesting nuggets that Huron has turned up in building their database of restatement information gleaned from 8-K filings over the years.

For instance:

    ♦ The average time between the filing of the initial Form 8-K and the filing of the restated financial statements was seven weeks; the median was three weeks. That's because some restatements take a couple months, and others stretch over a year.

    ♦ About one out of every six restatements captured by Huron was filed within a day of the Form 8-K; about one-third of the restatements were filed within two weeks of the initial filing.

    ♦ About 80% of the restated financials were filed within four months of the first 8-K warning of non-reliance on financial statements.

    ♦ About 19% of the time, the restated financials encompassed more accounting issues than were originally identified.

    ♦ The nature of the accounting issue didn't matter when it came to how long the restatement took to complete. The same five issues were the most common in the restatements that took more than four months to complete as the ones that were accomplished more quickly. Those issues: equity/debt classification, capitalization/expense issues, reserves/accruals/contingencies, revenue recognition, and taxes.

    ♦ Company size had no bearing on the speed of the restatement process.

    ♦ High-tech firms took longer to restate than "old school" manufacturers.

Investors are often aggravated by the restatement process, which can seem to drag on forever when you want to evaluate a company based on complete facts. Hats off to Huron: knowing these parameters won't make investors welcome restatements, but at least they've provided some realistic, quantitative descriptions of the process that makes it easier to bear.

Yesterday, Dell released its long-simmering fiscal year 2007 10-K , including restated information for prior years. The table below, culled from the 10-K, summarizes the adjustments made by category.


                                      February 3,     January 28,     January 30,     January 31,       2006     2005     2004     2003       (in millions)     Beginning retained earnings as reported

  $ 9,174     $ 6,131     $ 3,486     $ 1,364   Revenue Recognition:


    (21 )     (9 )     (7 )     (2 ) Other

    (216 )     (217 )     (102 )     (64 )                                   Revenue Recognition

    (237 )     (226 )     (109 )     (66 )                                   Warranty Liabilities

    202       223       129       31   Restructuring Reserves

    (18 )     (18 )     (14 )     80   Other

    (45 )     (35 )     (49 )     32   (Provision) benefit for income taxes

    21       4       11       (18 )                                   Cumulative adjustments to beginning R.E.

    (77 )     (52 )    ...

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Next week, I'll be part of the New York Society of Security Analysts "14th Annual Financial Reporting Conference" to be held in their offices located at  1177 Avenue of the Americas, 2nd Floor.

It should be a good gig. On the agenda: Complexity. Fair value reporting. Performance reporting. What's going on with the FASB, as told by Chairman Bob Herz. What's going on at the PCAOB, as told by board member Charlie Niemeier.

And I'll be on hand to blather about the international reporting issues raised by the SEC in their recent proposals on International Financial Reporting Standards, along with PwC's Marie Kling.

Come out for the day, if you can make it. Hey, it'll be Thursday - the next best thing to Friday. You owe it to yourself to get the facts on these issues, don't you? I hope I see you there.

As recounted in the Wall Street Journal ($) by David Reilly, the FASB narrowly voted to oppose deferral of the effective date of Statement 157, Fair Value Measurements. It was a 4-3 vote, as close as it can get. Recall that this wound up on the Board's agenda because of some last-moment requests for deferral by Financial Executives International and the Institute of Management Accountants. 

It didn't pan out that way. The Board may consider a deferral for nonpublic companies, and it might excuse nonfinancial assets and liabilities (from a business acquisition, for example) from Statement 157's scope, at least temporarily. No word on when that will be decided.

So, it looks like analysts will be spending a lot of time next year discussing fair value ... buckets. Specifically, Level 1 (best evidence of objective fair value); Level 2 buckets (no direct observable values, but imputed from other fair values), and Level 3 buckets (mark-to-model estimated values, 'cause there are no markets for any of the things. Voodoo!)

After yesterday, the lot of the investor is displayed (profoundly) in the first of these two photos. Actually, the first photo after applying a factor of three. And it was one vote away from the second photo.

This Wednesday, the FASB will decide whether or not to delay the implementation date on Statement 157, "Fair Value Measurements." That standard was to go into effect for fiscal years beginning after November 15 - little more than a month away. As noted previously, the Committee on Corporate Repotring of Financial Executives International sent a 12-page letter a couple weeks ago requesting the FASB to delay it.

According to CFO.com, the Institute of Management Accountants has also pushed the FASB to delay the implementation. No trace of their correspondence on the internet, yet, however.

We'll know Wednesday as to whether or not there's a grace period. One chief reason cited for delaying: supporting an "exit price" as required by 157 is too new to handle. That one seems far-fetched: an exit price is one of many possible prices that exist. It's more likely that in a period of price pressure as we're seeing in the markets for some financial instruments, no one really wants the extra trimming that an exit price might provide. A better reason for postponement - though not a new one - is that the IASB is considering the adoption of 157 as a convergence move. Is that really enough of a reason?