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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.

On Wednesday, the FASB will take another look at the effective date to be inserted into the exposure draft of the forthcoming amendments to Statement 140 and Interpretation 46R. These amendments, covered before in the May Accounting Observer and in subsequent posts, will make full consolidation of the vehicles used in securitizations much more likely. In other words, after these amendments go into effect, firms might still securitize loans - but the loans will still exist on their balance sheets and a liability shown for the amount of the "pass-through" security created in the securitization. The traditional "sale treatment," where the assets are derecognized and the pass-through liability instrument isn't shown on the securitizer's balance sheet, would likely be a much rarer find. The likelihood of these amendments being in place by year-end is getting pretty slim. It's now the end of July, and there's no exposure draft; indeed, the topic on Wednesday is directly related to the tardiness in completing a draft. There needs to be at least a 45-day comment period for the proposal, if not a longer 60-day comment period. If the draft was complete two months ago, there would not be debate now about the effective date. The effective date, considered this far, works like this: new securitizations would have to be evaluated under the new rules, potentially putting the full-strength transaction on the balance sheet of the sponsor, for transactions occurring in the first fiscal year and interim periods beginning after November 15, 2008. A bank with a calendar year end making a securitization in the first week of January would then have to evaluate such a transaction under the revised rules: a bulkier balance sheet would probably result, when the first balance sheet is reported on March 31, 2009. For existing securitizations at the 11/15/08 effective date, the same principles would be applied - but there would be a full year grace period. Those old securitizations might not pop onto the bank's balance sheet until March 31, 2010. (Assuming that they would have to be consolidated.) As reported before, banks don't like this (like Citigroup); trade groups don't like this (like the American Securitization Forum). Now there are others getting into the act, pressuring the FASB to delay. Last week, Ranking Member of the House Committee on Financial Services Spencer Bachus wrote to FASB Chairman Bob Herz and SEC Chairman Christopher Cox, asking them to - what else? - slow down the process on amending Statement 140 and Interpretation 46R for an additional year: "Changes to securitization accounting could have a dramatic impact on the economy, the capital markets and consumers seeking credit. With capital and liquidity at a premium, the effect of these changes could be to prolong market dislocation." Those concerns are rather patronizing of investors, in several ways. There's a presumption that investors are better off right now with crummy information about risks and leverage being taken on by firms when they engage in securitizations. Don't fix the accounting right away, because the market has been dislocated. So - keeping investors in the dark longer would be better? Or does that mean that a certain level of securitizations have to be floated to get the lenders back in the game, over the course of the next year? Then it will be okay to fix the accounting? Of course. Fix the accounting after investors in securitization-sponsoring firms have been kept in the dark about the level of risk and liability being undertaken by the firms in which they've invested. That's a sure-fire confidence-builder, a really good way to engender trust in the markets. Extensions of deadlines beget more extensions of deadlines. If the delay doesn't work and the markets are still in deep trouble, the delay will be extended again at the request of some other Senator or Congressman. And if there is a recovery, the banks and their ilk will not welcome changes that make them look more leveraged; they'll cite the success of a recovery without the revised rules and resist them. The more time that elapses before a standard becomes effective, the greater the opportunity for its foes to find a way to delay the standard once again. It would be better for the FASB to stick with their existing plan for the two-tiered approach to implementation of the new rules: ♦ The firms that are likely to be affected by this - the major banks - have not been caught flat-footed by these proposals. They have long known what would likely be required. ♦ The existing plans would affect only new securitizations immediately. Not everyone must do securitizations; and some might choose to pass, anyway. The securitization market isn't what it used to be, nor is it likely to be again. ♦ Investors will be better served by not having solid recognition principles in place for such leveraged creations sooner? In recent weeks, the market has gotten hot and messy over estimated amounts of additional leverage that have been pitched by analysts. Might the markets not be more confident if more reliable, factual numbers were added to balance sheets based on genuine accounting standards, instead of educated speculation? ♦ Firms applying the new accounting to new transactions would be able to hone their skills over the coming year in restating the old transactions. The changes the FASB is proposing are not new, and not...

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Revenue recognition has always been one of the more deceptively complex accounting issues. You think that there's a sale when there's delivery of a product or fulfillment of a service - but things like a right of return, or customer creditworthiness, or multiple deliverables promised, to name few, serve to muck up the recognition picture. (Among other things, like false invoices, premature shipping of goods, lowball estimates of doubtful accounts reserves - to name a few.)

CFO.com reports on the FASB's decision last week to issue a discussion document in the fall that would unify the plethora of accounting standards now existing regarding revenue recognition. It's more of a "thought piece" with a four-to-six month comment period; a full exposure draft will arrive in fall of 2009, with a final standard to be issued by mid-2011.Ambitious, yet possible.

Can't wait for the discussion document to show up? You can get a handle on what it will cover by taking a look at the handout from the last Board meeting. Link here for your fix.

The auditing profession has been lusting for caps on their legal responsibility for failed audits for some time now. The failure of Arthur Andersen has played nicely into their hands in this regard, allowing them to invoke the doomsday scenario of "what would life be like if there were only three major auditing firms?" Therefore, they need protection from lawsuits that could make this a reality. 

The funny thing is - the audit is under the control of the auditor. They could "audit better," if they chose to do so. And they could walk away from audits that they cannot audit better. Better that they have limits to their legal responsbility? Hmm... seems like they'd have even less incentive to do an audit better. I smell a moral hazard in the offing.

 There's an idea floated by Professor Lawrence Cunningham of the George Washington Law School that's worth considering, and he blogs about it in his post at the Concurring Opinions blog. Skip the caps: instead, have the auditing firms issue catastrophe bonds as a backstop for liability above the limits of their insurance policies.

 "The firms would issue bonds in debt markets to provide a backstop against the big judgment. Paying a high interest rate to reflect risk, the bonds would be repaid at maturity if no big claims arose but principal would be released to cover massive judgments if they did. This would protect share owners against losses from incorrect accounting without bankrupting an audit firm."

 It's a fascinating notion, one that might be worth some effort on the part of the auditing firms to consider. One puzzle: if a market could be found/created for these bonds, why wouldn't insurance firms just underwrite the risks in that particular market?

 Will auditing firms give it serious consideration? They should, but they're probably far too wedded to their lobbying efforts to minimize liability to pay much attention to it.

Saturday's New York Times featured a front-page piece by reporter Stephen Labaton on the forthcoming timetable to be set by the SEC for American companies to use IFRS - and mutual recognition of the enforcement agencies regulating foreign brokers, enabling foreign brokers to sell directly to Americans. 

"The S.E.C. also plans to announce details of a pilot program that would enable foreign brokers to deal directly with American investors, while continuing to be largely regulated by the foreign country. The first country in the program will be Australia, although officials hope to eventually include other countries."

On top of that:

"In a third move, the Public Company Accounting Oversight Board, which works under the supervision of the S.E.C., is preparing a rule that would allow it to defer to foreign regulators for inspections of some of the 800 foreign auditors of overseas companies that sell stock in the United States."

It's a good article for people just wondering how many things can be going on at one time. It also raises the question of whether all this activity is for the good of the investor - or just politics as usual as an administration comes to a close. And maybe the best quote in Labaton's far-ranging article is this one:

"James D. Cox, a securities law expert at Duke Law School who returned this week from teaching corporate law in Europe, said the shift to international rules amounted to “outsourcing safety standards.”

“We would not for a moment tolerate having American auto safety standards set by China or India,” he said. “Why should we do it for financial safety standards? There has to be some accountability.”"

The SEC has been pitching internationalization of markets like there's no one trading here any more. It's a good scare tactic, and it's effective for getting people to think their way. Accountability is a non-starter: it's the Achilles heel of these efforts, and there will probably be a good deal less of it.

Hitachi's XBRL Business Unit runs a blog on all things - what else? - XBRL. One of their regular contributors, Bob Schneider, asked me a few salient questions about the acceptance of XBRL in the analyst/investor community.

I hope I came up with a few salient answers. Bob thought they were good enough to show to the XBRL community; now I'm linking it here for your perusal. Hope you find it interesting.

The "death by delay" strategy seems to live on. Probably because it's working.

On Friday, the SEC announced that they will give another year of clemency to small companies (under $75 million market capitalization) for complying with Section 404 of the Sarbanes-Oxley Act. You know, the part that has to do with making sure that internal controls are in place and working - and that auditors agree with managementthat said controls are working.

The rationale: "The extension of the Section 404(b) compliance date for smaller companies is the latest in a series of Commission efforts to help reduce unnecessary compliance costs for smaller companies while preserving important investor protections."

Ah. Internal controls, and proving that they exist, are "unnecessary compliance costs for smaller companies?"

After this extension for small firms - I think it may be the fifth or sixth - they should just come clean and make an exemption instead of dressing it up as "studying the problem." It's already a de facto exemption, on a year by year basis. 

In other news, the SEC laid the groundwork for more study of the problem. They announced the blessing from the Office of Management and Budget for a "real-world" cost-benefit study on the Act's internal control provisions, to be carried out jointly by the SEC's Office of Economic Analysis, the Office of the Chief Accountant, and the
Division of Corporation Finance. Maybe their work will provide the groundwork for a real-world exemption. The announcement said nothing about the timing of the completion of their study, but it will have to be done pretty quickly if they want to get something effective by the end of the year - concurrent with the completion of this edition of the SEC.

And in fine form, I might add. Though it's cartoon form this time.

Have a chuckle at "Green With Envy" by Merle Hazard. You remember Merle: you know, the man who brought you "H-E-D-G-E" and "In The Hamptons."

Thanks to Jon Shayne for the tip that Merle's back in action.

Last week, the SEC announced its intention to overhaul the existing disclosures required of oil and gas companies. They've been locked into a disclosure format over 25 years old, one that states reserves on a stringent, consistently-calculated basis. While that "stringent, consistently-calculated basis" provided a good platform for comparisons, it didn't take into account the improvements occurring in oil drilling and gathering technology since the 1970's.
Whatever form the new disclosure takes, it's likely oil and gas companies will show improvements in the amount of their reserves versus the levels they're showing now.

That's kind of ironic: when the disclosures were first mandated, the world was expecting oil reserves to steadily drop. Now, 25 years later, the companies will likely show increases. Hey, technology marches on.

The press release didn't mention timing of the proposed rules or how long investors will have for commenting on them. It will be interesting to see how "principles-based" the rules may be. It's also interesting that the Commission didn't bother to try and get the FASB (or the IASB) to take up this project. They simply issued their Concept Release last year and ran with it. It might have been a good joint project for the two of them - but it would probably never be completed by the end of the current SEC's administration.

Last week, I took part in the FEI Conference called "The World Is Moving To IFRS: Are You?" The keynote speaker was John White, director of the SEC's Division of Corporation Finance. While it would have been great to hear him discuss the SEC's IFRS "roadmap," it was not to be. The fact that it hasn't been released by this time leads one to believe that a rule won't be issued before the end of the SEC's current administration: it would be difficult to get a rule of this magnitude out for public comment and have it completed before the end of the year. Indeed, according to the FEI Blog, White's comments to the press after his speech indicated that "the roadmap will not be proposed rulemaking per se, although proposed rulemaking may be one of the signposts along the roadmap."

So, it may be along the lines of "speech GAAP?" Hmmm. We'll have to see how the roadmap gets positioned.

Back to the nitty-gritty. White raised the point that "...
in the coming months as the IASB continues its work, including with regard to addressing possible gaps in IFRS, I look forward to the possibility that we in the U.S. will have some involvement in the standard setting process itself. And this is just one of the reasons that it is important for U.S. companies to be able to use IFRS, and maybe even be required to use IFRS. The thought here being that, in order for the U.S. to fully input in the standard setting process for IFRS, a portion of U.S. companies should be using IFRS. To the extent appropriate, our resources can be applied as IFRS are written and be persuasive or supportive of one position or another. But U.S. views and experience would likely be more persuasive if U.S. companies were using IFRS."

A good point - but one that makes it clear that U.S. companies have to be allowed to use IFRS. And if the IASB continues its work in addressing gaps in IFRS "in the coming months," and US companies would be more persuasive in addressing them if they were using IFRS, you have to wonder if there's going to be some hurry-up optionality in allowing companies to use IFRS sooner rather than later.

While that's a logical premise, it would be awfully difficult for investors to deal with. U.S. GAAP already has many choices of accounting treatments in it, and adding a broader layer of optionality will make comparisons even more difficult for them - especially if they are unfamiliar with the IFRS choices companies make.

White mentioned that implementation "will be a key consideration for the Commission." Here are the questions he raised "that should be part of the public debate about any U.S. transition to IFRS:" 

  • Should all U.S. companies simply be mandated to start using IFRS in their SEC filings as of a certain date?
  • Should there first be a period in which U.S. companies have the option to use IFRS in their financial statements, and if so, how long should such a period be?
  • If there were such a period of optional use, would U.S. companies feel inclined to change to IFRS unless it were clear that mandated use of IFRS was in the foreseeable future?

My favorite idea (if we're convinced that IFRS is a high-quality set of standards, that is): mandate all companies to use IFRS as of a certain date, say 3 to 5 years from the date of the issued rule. No optionality in between, but be prepared to present all regularly-reported financial information on a retrospective IFRS basis when the switch gets flipped at that certain date. That would give companies ample time to develop the information as they go along; it will provide information to markets on a complete and consistent basis; and it will give investors, educators and practitioners time to evaluate their situations. 

Last Friday, the SEC settled charges with Analog Devices over fraudulent misstatement of income for the year 1998 through 2002.

As is the tradition in these cases, the company neither admitted or denied its wrongdoing - and the same goes for the CEO Jerald Fishman, who had been charged along with the company. Analog escapes with a $3 million civil penalty; Fishman, a $1 million civil penalty and a disgorgement of $450,000, plus prejudgment interest of $42,110. The disgorgement is the amount of "in-the-money" benefit that accrued to Fishman from selling stock obtained through a backdated option grant.

The amount of understated compensation expense in the period relating to three grants: $30.7 million pretax, $21.8 million aftertax. The company also had a shoddy practice of granting options just before the release of favorable public information  - and this was not a basis for the actions against the company, because the practice predated 2006 proxy disclosure rules that required disclosure of grant practices. Slimy, nonetheless.