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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.

Last Friday, the SEC signed protocols with the securities regulators of four other countries - Belgium, Bulgaria, Norway and Portugal - to share information on the application of International Financial Reporting Standards in each others' countries.

The protocols are more or less the opening up of formal channels of communication - they're not a commitment, they don't create new rights or supersede old agreements. They mostly establish an intention to cooperate between the US and the other countries. They follow a similar protocol signed about a year ago with the United Kingdom's Financial Services Authority .

It's a good thing that the SEC has decided not to travel alone on its journey to international accounting standards. These countries have had more experience in the application - or misapplication - of International Financial Reporting Standards, and there could be valuable lessons for the SEC to apply.

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Speaking of IFRS...

Next week, on June 5, I'll be a member of a panel on IFRS at a conference in New York City. It's sponsored by Financial Executives International and it's entitled "The World Is Moving To IFRS: Are You?"

Well, it's not like you have much of a choice any more. It also doesn't look like there's much choice if you want to attend the conference: it's sold out, but wait-listed, from what the website says. With guests like FASB's Suzanne Bielstein, the IASB's Wayne Upton and John White of the SEC, it's sold out with good reason.

Also next week: on Monday, June 2 I'll be a guest panelist on a FASB webcast on the credit crunch and fair value reporting entitled "The Crisis in the Credit Markets: Causes, Reporting Issues, and Responses." The price is right on this one: free. And you don't have to get out of your chair. I hope you'll tune in Bob Herz, Matt Schroeder (of Goldman Sachs), Ray Beier (of PricewaterhouseCoopers) and me at 2 pm next Monday.

By the end of the month, to be exact. This article from Dow Jones Newswires might mean that some SEC staffers are going to have a busy Memorial Day weekend.

In a May 9 memo to agency heads, White House Chief of Staff Josh Bolten wrote that "all rules to be finalized before the administration leaves office should be proposed by June 1, and final rules should be issued by November 1."

That means the SEC's IFRS roadmap should be published by the end of the month and completely ready to roll by November 1. The memo mentioned that "extraordinary circumstances" might make for allowances; but the June 1 deadline seems consistent with the SEC's timing all along. The White House edict might just seal it.

Statement No. 162, "The Hierarchy of Generally Accepted Accounting Principles," was issued last Thursday. It's not a standard that will drive investment decisions - but if you're an investor who's in a conversation with a CFO and the subject comes up, it might help to understand what the of "GAAP hierarchy" comes up, it might help to know a little bit about it.

Here's the background. The American Institute of CPAs had long decided what constituted the strength in various "levels" of generally accepted accounting principles because their constituents - auditors - needed a consistent policy on how to handle conflicts in accounting literature when more than one standard might be found on a single topic. Hence, there were "levels" with in the "house of GAAP," as it's frequently called. When the AICPA dictated auditing standards, it mattered that they be the ones to establish the hierarchy - but that right was removed with the establishment of the Public Company Accounting Oversight Board in 2003. The right to set accounting principles was also removed from the AICPA by the Sarbanes-Oxley Act: it required the SEC to appoint a single accounting standard setter for the establishment of accounting standards. And it picked the FASB, not the AICPA.

The FASB has now revised the standards hierarchy; it's absorbed many AICPA standards into its own domain. They didn't simply vanish along with the AICPA's authority. Here's how the new hierarchy of generally accepted accounting principles shapes up, in descending order of authority:

♦ FASB Statements of Financial Accounting Standards and Interpretations, FASB Statement 133 Implementation Issues, FASB Staff Positions, and American Institute of Certified Public Accountants (AICPA) Accounting Research Bulletins and Accounting Principles Board Opinions that are not superseded by actions of the FASB

♦ FASB Technical Bulletins and, if cleared2 by the FASB, AICPA Industry Audit and Accounting Guides and Statements of Position

♦ AICPA Accounting Standards Executive Committee Practice Bulletins that have been cleared by the FASB, consensus positions of the FASB Emerging Issues Task Force (EITF), and the Topics discussed in Appendix D of EITF Abstracts
(EITF D-Topics)

♦ Implementation guides (Q&As) published by the FASB staff, AICPA Accounting Interpretations, AICPA Industry Audit and Accounting Guides and Statements of Position not cleared by the FASB, and practices that are widely recognized and
prevalent either generally or in the industry.

The hierarchy still needs to be approved by the PCAOB to be completely effective on the auditing community. When you look at how many sources of accounting principles still exist after the clean-up, you can appreciate the calls for simplicity and the arguments made in favor of International Financial Reporting Standards. Make no mistake however: the more popular they become, the more interpretation and guidance they'll require. It wouldn't be surprising to IFRS principles grow at a rapid clip over the next few years.

Last month, subscribers to The Analyst's Accounting Observer received our report on the state of benefit plans in the S&P 500 Short version: they're in pretty good shape, but far from riskless. And we'll be monitoring them throughout the remainder of the year to assess the risks.

If you're an institutional investor and would like to take a free trial offer of the Accounting Observer, you're welcome to this report. Click here to register for the trial, and you can also register seven of your research comrades. Institutional investors only, please: if we can't find you in one of the major directories of investment research (StreetSight, BigDough), we won't honor your request.

The timing of that report was pretty fortunate: in March, the FASB proposed amping the disclosures about benefit plan assets. While we were working on the report, we got a first-hand look at the existing disclosures and their shortcomings in light of the market events of the past year. It gave us good feel for how the FASB's disclosures could benefit investors. The deadline for comments on the proposed FASB Staff Position was shortly after we completed the report, so I put together a comment letter of my own just in time for the deadline. It's available here for your reading.

The disclosures should be effective for the years ending after 12/15/08. I have no doubt that companies will vigorously oppose the proposal and at least try to stall for another year of grace. It's an iron rule of accounting standard-setting: the amount of corporate resistance is directly proportional to the amount of informational benefit a proposal will provide to investors. We'll see if it happens here.  

Further evidence that the world is getting to be a smaller place every day. And that the SEC's blueprint for moving the US to international financial reporting standards is just around the corner...

On June 16, the FASB will hold a forum at Baruch College, entitled "High-Quality Global Accounting Standards: Issues and Implications for U.S. Financial Reporting." Panelists will be "users of financial statements, representatives of small and large companies both public and private, auditors, regulators, educators, and others representing facets of the U.S. economy that would be affected if there were a move from U.S. Generally Accepted Accounting Principles (GAAP) to International Financial Reporting Standards (IFRS)."

If there were a move? Maybe we'll understand the "if" a little more after the SEC blueprint hits the 'net. I suspect that it will be out before this forum; it would make sense for the FASB to schedule such a production for a time frame after the SEC's plan becomes public.

Other international news: the FASB has signed a "Memorandum of Understanding" with their Chinese counterpart, the China Accounting Standards Committee, committing "to strengthen cooperation and communication between the two standards-setting organizations." More specifically:

  • The two bodies will work to improve understanding technical issues "to facilitate economic interaction between the two countries";
  • They'll exchange experience of accounting standard setting, implementation, and international convergence; and


  • They intend to "exchange opinions regularly and build the technical foundation for sharing views on convergence of accounting standards."

This internationalization of accounting standards is happening faster than investors realize, because it hasn't resulted in changes to standards or financial statements - yet. That's typically how investors find out about what's going on in the accounting world - when it's after the fact and it's baked into the financials. When internationalization is in full swing, I suspect there will be a lot of head-scratching by investors.

A reminder, though I'm sure you know: it's Berkshire Hathaway's shareholder meeting weekend. The carnival of capitalism is a spring ritual for the true believers, and every year it becomes a bigger and bigger event. All the disciples of Buffett, who attend perhaps in hopes of channeling their inner billionaire, hang on every word looking for the version of investing truth they want, somewhere in his comments.

This year, it promises to be even more exciting: the search for hidden messages will be even more intense because of last week's announcement of the purchase of Wrigley by Mars and Berkshire.

(Author's note: I, and accounts I manage, own both Berkshire and Wrigley.)

I won't be attending the meeting. I used to go to it, back when it was small - oh, say only about 3,000 attendees. Intimate, by comparison to today's mob. The coverage of it has been terrific over the years: I can't say it's as good as being there, but being there isn't quite as good as being there, either. There's only one Buffett (and one Munger); their results speak for themselves, and they say a lot. I'll content myself with the media coverage, I guess. I understand that Fox Business channel will be covering it all weekend long, and capping it off with an hour-long interview with Buffett on Monday morning. (In case you're interested.)

You might reflexively think about a possible combination of US accounting standards and international accounting standards, but no - the urge to merge internationally is what's going on at Ernst & Young .

The firm announced the merging of "87 country practices in Western and Eastern Europe, the Middle East, India and Africa into a new EMEIA Area." That's not all: the 700 partners in the Far East practices supported a similar move across 15 countries and territories.

The EMEIA Area will operate as a single unit, led by a single executive team and, where allowed by laws and regulations, be underscored by formal combinations of practices. The new Area will be a US$11.2 billion organization with more than 60,000 people. The 3,300 partners of EMEIA will vote on the integration by the end of May. The new EMEIA Area will be effective from 1 July 2008.

The integration of the Far East Area creates a US$1.2 billion organization, with more than 20,000 people. The new structure will also be effective from 1 July 2008.

That doesn't make the firm suddenly bigger or grow more quickly. And it doesn't really change too much for the investor. What's interesting though, is that it gives a couple glimpses inside the auditing world that investors rarely get. First, the sheer size of a Big Four organization is something investors rarely contemplate. The EMEIA area alone will be an $11.2 billion organization, meaning it's hugely important to the firm as a whole: last year, E&Y's global revenues were $21.1 billion. That puts them in the same league as Electronic Data Systems or Constellation Energy Group; ahead of JC Penney or Tyco. Yet investors rarely consider the size and reach of these firms that are acting as their agents in the auditing of financial statements.

The other glimpse: note that these practices were under the E&Y tent, but as different country practices. It's not like all of the firms within the firm are necessarily as uniform as investors might believe. Going forward, there should now be a high degree of consistency and uniformity in the way these practices operate within E&Y. That's something that should matter when say, a Peoria-based audit client has a significant business unit in the Middle East that's audited bythe EMEIA arm of E&Y. Yet investors never wonder much about how the audit gets done until a failure shows up. Nor is there much information available about how the audit gets done.   

Former Fannie Mae CEO Franklin Raines, along with former CFO Tim Howard and former controller Leanne Spencer, settled with its regulator, the Office of Federal Housing Enterprise Oversight,  last Friday.

Recall that Fannie Mae famously abused its accounting for derivative transactions and fee recognition, and has taken years to bring its financials statements back up to the present. According to the OFHEO release, Raines will pay $24.7 million, comprised of:

"The proceeds from the sale of Fannie Mae stock, valued at $1.8 million to be donated to programs and initiatives to assist homeowners threatened with the loss of their homes or related initiatives to assist homeownership, as approved by OFHEO.

Payment of $2 million to the United States Government.

Surrender and relinquishment of claims related to stock options with a value of $15.6 million when they were issued.

Other benefits lost in association with the above estimated at $5.3 million."

It's easy to picture Mr. Raines standing in a corner, with his head hung in shame. In reality, he's probably doing a victory dance: originally, OFHEO had hoped to win $115 million from him. And the Washington Post paints a very different picture of the composition of that $24.7 million:

"The agreement includes stock options worth $15.6 million at the time they were issued; those options are currently under water. They entitled Raines to buy shares at prices of $77.10 and higher. Fannie Mae's shares are currently trading at about $29, so the options Raines is surrendering would not produce any benefit to him unless the share price rose dramatically, according to sources familiar with the settlement who spoke on the condition of anonymity because they did not want to be seen as criticizing the regulator.

OFHEO said Raines's settlement also includes the payment of $2 million to the federal government. That sum would be covered by a Fannie Mae insurance policy, the sources said.

The settlement also includes proceeds from the sale of stock worth $1.8 million, to be donated to programs aimed at assisting financially strapped homeowners. Those are shares Raines had been fighting in court to obtain from Fannie Mae."

Doesn't seem to carry quite the same sting, does it? Not only is the settlement vastly reduced from the original amount of damages sought, the party that Franklin injured - Fannie Mae and its shareholders - wind up picking up the tab for his malfeasance. The terms were similar for Howard.

Is this a great country or what? It's getting to be a weird country, that's for sure.

Last week's Barron's contained a good story  by Andrew Bary on gains being recognized by investment banks on their marked-down debt. I've been a bit surprised by the number of people who've asked about this in the following week: it's not new news. I wrote dedicated reports about it last March, again in June, and once more in November. And it's not as scary as it sounds - Bary's piece was sharp and insightful, and shows that there's a skeptical audience out there when it comes to including such gains in the earnings stream that investors should capitalize. And he quoted some other knowledgable folks who believe this kind of earnings element should not be capitalized by investors.

Got that? D-O N-O-T C-A-P-I-T-A-L-I-Z-E. It's about the same level of quality in earnings that you'd expect from a sale of sale of equipment or a product line. Nobody would capitalize that in the stock price.

"Do not capitalize" is not the same thing as "Ignore." There's still information in those gains - some of it pretty obvious at first, in the case of the investment banks, less obvious if it occurs in something like industrials.

Wrap your head around the concept behind recognizing a gain on a liability depreciation before going too far. Think of something on the asset side of the balance sheet: a debt instrument held by a firm as an investment. The debt instrument increases in value because the company is an improving credit. The appreciation goes into income and it's non-cash. It can't be spent. Market participants probably wouldn't get too excited about that kind of earnings stream; they might figure that it could be easily converted into cash, but they also wouldn't expect it to be necessarily repeatable. On the other side of the balance sheet, if a firm's liability decreases in value, the market for the debt is giving the company an opportunity to improve itself: it'll take less cash to retire some of the debt. Forgiveness of debt is a gain, in anyone's book.

Neither side is a completed transaction  - the firm doesn't sell the debt instrument, nor does it buy back its cheaper debt. Both ingredients go into income anyway, and the investor's job is to sort out what they don't like, as they always have. And the disclosures are good enough that discerning guys like Bary can pick out the skeevy earnings effect. (Another good piece in a similar vein was done by Jesse Eisinger in Conde Nast Portfolio last month.)

The balance sheet is just showing what it's supposed to show: the firm's rights and responsibilities at a given point in time. If the written down debt is available, managers ought to consider buying it in just as if it were stock.

On to the the finer points on the markdown of debt, some additional information it provides: you've got credit markets saying that the firm's prospects stink. That's valuable information that investors should take into account and they wouldn't have it if there wasn't a mark-to-market on the debt. If the credit markets see a freight train coming, one should look for a corresponding writeDOWN of an asset on the other side of the balance sheet - and if there isn't one, they should suspect that one may be coming. This is pretty obvious in the case of investment banks; if you saw something like this happening on an industrial firm's balance sheet, you might be getting an insight you wouldn't expect. Regardless, these gains are not the gravy train the Statement 159 electors think it is.

So far, these are pretty rare: to get this kind of treatment last year, a firm would have had to make an election to do so in the first quarter of 2007. By our count, only 68 firms adopted this treatment in 2007, with financials far and away the majority. More will have a chance to do so in the first quarter of 2008.

I believe we'll soon be hearing about the SEC's plans for allowing companies to use International Financial Reporting Standards here in the United States. The Public Company Accounting Oversight Board, a sort of subsidiary of the SEC that provides oversight of the accounting firms that audit publicly-traded companies, issued its strategic plan on March 31. Some of the goals listed in the document indicate how seriously the PCAOB is taking the pending convergence of US and international accounting regimes. Mentioned as a development that may impact the PCAOB's programs and operations:

"...The SEC has undertaken certain rulemaking initiatives related to the acceptance of financial reporting in IFRS. In particular, the SEC adopted rule amendments allowing foreign private issuers to prepare their financial statements inaccordance with IFRS, without a reconciliation to U.S. GAAP. Based on this rule change, the PCAOB has devoted and plans to continue to devote resources to, among other things, training staff in IFRS. If the SEC were to require U.S companies, or give them the option, to prepare their financial statements under IFRS as opposed to U.S. GAAP, the PCAOB would have to devote additional resources to IFRS training to supplement the training described above, as well as possibly recruiting individuals with knowledge and expertise in IFRS. In addition, the Board would have to evaluate the need for any additional adjustments to its programs and consider the need for new initiatives to prepare for such a significant transition in financial reporting and address any concomitant risks related to public company auditing. In any event, the PCAOB plans to consider its relationship with the International Accounting Standards Board (“IASB”) to stay abreast of accounting developments and enhance the IASB’s appreciation for the effect of its work on public company auditing."

One doubts that this would be at the top of the PCAOB's list of possible developments that could impact its operations if it wasn't likely to become a reality. Also, the PCAOB expects to inspect 72 non-US registered accounting firms in 2008. That number is projected to grow 40% in 2009 to 101.

It seems as if the IFRS groundwork is being put into place, quietly. Stay tuned.

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Also: a hearty, walloping "thanks!" to Business Week for naming The AAO Weblog in its "Financial Blogs: Best of the Bunch" roundup in this week's issue. It's an honor.