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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 Friday, the Financial Accounting Foundation appointed Marc Siegel, leader of the Accounting Research and Analysis Group at RiskMetrics Group, to take over the board post currently held by George Batavick, who will retire from the FASB.

I've known Marc from our membership on the Investors Technical Advisory Committee since it started in January 2007. I think he'll be a fine addition to the slimmed-down board - and he's going to be joining it a pivotal time in the Board's history, as it faces the fallout from the Wall Street bailout bill - including a hostile pushback of fair value accounting. Not to mention the IFRS convergence efforts, which seem to have been forgotten in the last couple of weeks by most observers of the financial reporting scene. (With good reason.)

I'm sure Marc will do a fine job and will bring a keen understanding of the investor's point of view to the table. Good luck to him, and best wishes to George in his retirement.

From the Angry Bear blog (and soon to be in every American's email inbox):

Your Urgent Help Needed

Dear American:

I need to ask you to support an urgent secret business relationship with a
transfer of funds of great magnitude.
I am Ministry of the Treasury of the Republic of America. My country has had
crisis that has caused the need for large transfer of funds of 800 billion
dollars US. If you would assist me in this transfer, it would be most
profitable to you.

I am working with Mr. Phil Gram, lobbyist for UBS, who will be my
replacement as Ministry of the Treasury in January. As a Senator, you may
know him as the leader of the American banking deregulation movement in the
1990s. This transactin is 100% safe.

This is a matter of great urgency. We need a blank check. We need the funds
as quickly as possible. We cannot directly transfer these funds in the names
of our close friends because we are constantly under surveillance. My family
lawyer advised me that I should look for a reliable and trustworthy person
who will act as a next of kin so the funds can be transferred.

Please reply with all of your bank account, IRA and college fund account
numbers and those of your children and grandchildren to
wallstreetbailout@treasury.gov so that we may transfer your commission for
this transaction. After I receive that information, I will respond with
detailed information about safeguards that will be used to protect the

Yours Faithfully Minister of Treasury Paulson





Much political hay will be made this week over the proposed bailout bill. Could anyone have scripted a more bizarre scenario only a month and a half away from the national election?

While the candidates duke it, figuring which way a position will garner them more votes from the other or get thos undecided voters to decide in their favor, there will be another fight going on: the battle to dump fair value accounting.There are rumors of legislative action that calls for a moratorium on Statement 157.

As if Statement 157 had anything to do with the crisis. Understand one thing if nothing else: if a bank or investment firm makes serial horrendously stupid investment decisions, like continually lending money to people having no wherewithal to repay, hiding that fact from investors will not make you whole. It will not resolve a liquidity crisis. Fair value reporting tells investors what assets are worth, and gives investors a heads-up on managements' stewardship of assets.

The problem with fair value accounting now is that it's telling investors that there wasn't much stewardship at all. Go back a few years, when these firms were reporting record earnings: did anyone question fair value reporting then? Of course not. It's a different story when fair value reporting shows culpability.

The current "blame the accounting" mode is like berating the UPS delivery man who brought you a pair of tan Gucci loafers instead of black ones you ordered. What did UPS have to do with faulty goods? Nothing; Gucci screwed up. What does Statement 157 have to do with crummy asset values? Nothing. Managers screwed up.

It's doubtful that many critics of Statement 157 actually ever read it. If they did, they might actually see that this didn't sweep in any broad new applications of fair value reporting. The last standard that required many new applications of fair value accounting was Statement 133 on derivatives - back in 2000. Firms have always been required to write down impaired assets. There's never been a bye to just leave junk on the balance sheet, even before Statement 157.

What's different now? Two things. Statement 157 requires far more disclosure about the nature of financial instruments gracing the balance sheet. Firms always had to take a stab at the value of a security before; now when they do, investors have an idea of how that figure was developed - so they can believe it or not. Hence, the disclosures about Level 1, 2, and 3 hierarchies of fair value. Sunshine on how numbers were developed: that's the biggest improvement in reporting to investors brought by Statement 157.

The second difference: the kinds of financial crud now subject to fair value reporting has never been this plentiful, thanks to the imagination of lenders and investment bankers who concocted CDOs, CDOs-squared, CLOs and all the other alphabet-named implosion devices. Of course they're hard to value; that just might have something to do with why they don't trade. If these things are now nearly worthless, why is it better to delude investors into believing they're worth something more? Just so the firms that made poor decisions can recapitalize themselves from deceived investors?

If there's anything that should have been learned from this fiasco, it's that markets need information to function well. It seems as if the firms that have tanked didn't even have good information INSIDE their own firms about risks, collateral and cash. Taking information away from investors not only puts them at a disadvantage in making investment decisions - it give the advantage to the already-inept. So how can you expect efficient capital allocation at a market level?

Last week, PCAOB member Charles Niemeier addressed a New York State Society of CPAs conference. He spoke his mind about the one-sidedness of the movement towards IFRS adoption in these United States. As reported by CFO.com, Charles raised the valid point: moving to IFRS can "put in jeopardy the thing that gives the U.S. a competitive advantage ... All research shows that the U.S. is unique in its regulation. No [country] is as effective . . . . We have the lowest cost of capital in the world. Do we really want to give that up?"

Apparently, the SEC doesn't buy into the research conclusions showing that the United States has the lowest capital cost on the globe. Although at the moment, with two major financial institutions going into either outright liquidation (Lehman) or de facto liquidation (Bear), and a government takeover of Fannie Mae and Freddie Mac, you'd have to wonder if our cost of capital is still the lowest in the world. If it isn't, it would be a mighty stretch to say our cost of capital rose because we're not on the IFRS train yet. Let's just say there are a few other possible reasons why our capital cost might be strained.

Niemeier goes on to explore myths about IFRS convergence, such as the fact that it's "principles-based," not rules-based.
"IFRS is not more principles-based, it's just younger," said Niemeier. He pointed out that the US once followed a more "principles-based" system - but a 1969 court decision, U.S. v. Simon, spurred the development of many rules because it found that simply sticking to generally accepted accounting principles is not a foolproof defense when charged violating antifraud securities laws. Auditors sought guidance from standard setters, and the house of GAAP grew into a skyscraper.

Another myth Niemeier took on: the use of IFRS will enhance comparability. While it may be that US financial statements might be more similar to those in other countries, there's an inherent contradiction in the "principles-based" dream. If "principles-based" standards allow companies and auditors to exercise more judgment, how can company-to-company financials ever be more consistent? Worse yet: if companies start to exercise "nostalgic accounting" by employing judgment in the application of IFRS that makes their results resemble their prior national accounting system results - and this may be happening already - how can expansion of IFRS make things more comparable?

His speech hasn't been posted on the PCAOB website yet, but when it is, I'll be sure to provide a link. I think he's on to a lot of the concerns that need to be addressed in accounting standards convergence. Investors are not served well if convergence is merely "convergence by decree" - something that happened when the SEC removed the reconciliation of IFRS to GAAP earlier this year. As Charles puts it, we need to "return to a policy of convergence to achieve something noble, not convergence for uniformity's sake. We should strive for comparability, not just say it."

WebCPA.com reports a survey of 535 accounting professors conducted by the American Accounting Association and KPMG showed that only 22 percent of them intend to incorporate IFRS lessons into their plans for the 2008-9 academic year.

Bad enough - but 62% of them "admitted they have not taken any significant steps toward doing so."

Don't they read the papers? You're entitled to wonder. One legitimate excuse offered by the profs: it's hard to fit anything more into the curricula. There's more justification for a mandatory five-year program.

The survey also showed that they didn't expect textbooks to be available on the subject until the 2010-11 academic year. They're probably right - but that doesn't mean they can afford to turn out students who will be facing new accounting challenges the minute they walk onto the job. There is a real opportunity here for schools to differentiate themselves from the pack. The ones that can develop a rugged program that at least teaches students IFRS rudiments - and how to continue learning afterwards - will be able to attract the best students and engender the best relations with the Big Four when recruiting time comes for their graduates.

Deloitte intends to lay off 900, or 2%, of its U.S. employees, according to this article by WebCPA. No official release by the firm could be found on their website, but the article cites an e-mailed statement from the firm. A clip:

"The cost-containment program is taking place across all support functions and client service units. Part of the plan is to align our headcount according to current and projected revenues."

"According to current and projected revenues?" Well, that says something about where Deloitte expects audit and consulting fees to go this year.

A little surprising, really - not so much that the firm expects pressure on its fees, but that the cuts are taking place across all client service units. You could expect that client firms might be doing more restructuring and requesting more advice in tough times.

It's not likely to last. The coming IFRS transition will provide many public accountants full employment for their lifetimes. It wouldn't be surprising to see Deloitte hire replacements for the 900 US members they're laying off - and then some - in the next couple years.

The big news last Friday: the Public Company Accounting Oversight Board doesn't look like it's in imminent danger of extinction. Remember that lawsuit charging that its creation was unconstitutional, filed back in early 2006? It was filed by a Las Vegas accounting firm with an axe to grind: they were being investgated by the PCAOB while being investigated themseleves.

For a while, it looked like it might actually lead to the demise of the PCAOB. A three-judge panel heard oral arguments in the case, and one of them was clearly sympathetic to the plaintiff.

Looks like it won't happen: not without an appeal, anyway. According to the Wall Street Journal, the plaintiffs plan to take it all the way to the Supreme Court, so it there's more ahead on this saga. SEC Chairman Cox weighed in favorably on the outcome in this press release.

Last week, the Governmental Accountability Office released a study of corporate income taxes paid for the years 1998 - 2005. Findings: for most of that period - roughly two-thirds of the time - firms did not report a US tax liability.

There was slightly more of a tendency for foreign-owned firms (50% or more of voting stock owned by a foreign entity) to report zero liability that for US-owned firms. In both cases (foreign-owned versus US-owned), firms paying no taxes tended to be smaller firms. (Firms were considered large firms if they had assets greater than $250 million and $50 million of revenues.)

Don't jump to conclusions about tax chicanery. There's one important attribute of the findings that the GAO listed in the first paragraph of the report:

"Most large FCDCs (foreign-controlled domestic corporations) and USCCs (US-controlled corporations) that reported no tax liability in 2005 also reported that they had no current-year income. A smaller proportion of these corporations had losses from prior years and tax credits that eliminated any tax liability."

So, while it carries a populist tune in an election year, some of that tax non-payment might be totally legitimate: income is a necessary condition for an income tax, right? And the crazy-quilt patchwork of a tax code lets firms turn losses into assets to be applied to taxes later, and credits shelter the income of favorite son industries. So that "two out of three IS bad" label might not really stick.

What it might mean though, is that the corporate tax code is badly in need of repair. That subject is nicely teed up in "A World of Wealth: How Capitalism Turns Profits Into Progress," which I enjoyed on my vacation last week. It's the work of Thomas Donlan, Barron's editorial page editor, and it's a terse primer on economics, capitalism and capitalistic solutions to modern problems. (Briefly: prices help do the job of solving most problems, and they do it best when they're left alone.) One issue Donlan raises: why have a corporate income tax at all? In the end, it isn't the company paying the tax; according to the GAO, there isn't even the appearance of most firms paying a corporate income tax in recent history. Where taxes are paid, however, the normal corporate behavior is to build the tax into the prices of the goods and services sold to consumers. Why continue the charade? Take the taxes off the corporations and everyone benefits - except maybe corporate tax shelter promoters, tax accountants and tax lawyers.

Donlan riffs on a variety of issues, from oil prices to greenhouse gases to immigration and taxes, with a zeal for capitalism that's clearly evident in his entertaining and breezy style. Quick, read it before the summer goes - and at the latest, before you vote in November.

Last August, the SEC formed an advisory committee to improve financial reporting. It became known in accounting circles as the "complexity committee" (though "anti-complexity committee" would make more sense) or CIFR (acronym for "Committee on Improvements to Financial Reporting). It was established with a one-year life span; making good on that timetable, the committee issued its final report on Friday. Some of their recommendations:

♦ A short executive summary at the beginning of a company’s annual report on Form 10-K with material updates in quarterly reports on Form 10-Q.

Why? "Many individual investors may find a company’s periodic reports overly complex and detailed. A summary would describe concisely the most important themes or other significant matters with which management is primarily concerned."

Sounds suspiciously like the attempts about fifteen years ago to introduce "abbreviated financial statements" into mainstream on the grounds that full-strength financials were too difficult to use for individuals. This creates the possibility to eliminate more information down the road in the name of "simplification."

♦ The Committee supports the SEC’s long-term efforts to introduce XBRL, and its gradual phase-in.

♦ They encourage the private sector to "develop key performance indicators (KPIs), on an activity and industry basis, that would capture important aspects of a company’s activities that may not be fully reflected in its financial statements or may be nonfinancial measures."

The idea behind KPI's is that these are the indicators or data points that managers use to run the business. Why, then, don't these already appear in the Management's Discussion & Analysis? That report is supposed to let investors see the business through the eyes of management.

♦ They recommend increased investor representation on the FASB and the Financial Accounting Foundation.

That is, assuming they'll be around long enough to matter, given the SEC's drive to make IFRS the law of the land.

♦ They recommend "increasing the field work for proposed standards and formalizing post-adoption reviews of new standards, as well as periodic assessments of existing standards."

This could lead to further standard-setting paralysis. It's not like standards have been thrown at companies that require factory recalls. When there is a delay or partial transition of a standard, it's usually because the affected firms have lobbied hard to slow things down. Setting up a mechanism like this would only give them more tools to impede progress.

♦ They support "creation of a Financial Reporting Forum (FRF), on which key public and private parties would be represented. The FRF would meet regularly to discuss the current pressures on the financial reporting system and how constituents are meeting these challenges."

Isn't this awfully similar to the Financial Accounting Standards Advisory Council? Would it really add more than an additional layer of bureaucracy?

♦ The committee recommends "a move away from industry-specific guidance in authoritative literature – unless justified by strong conceptual arguments. A better approach would be to focus on the nature of the business activity itself."

♦ The committee also recommends the SEC and PCAOB adopt policy statements on how they evaluate the reasonableness of a judgment.

Time will tell how many of these recommendations will become reality. You can bet there will be a lot of activity on them between now and the end of the year, when this iteration of the SEC finishes up.

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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