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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 week, Eastman Kodak was in the news: it was the first major company to disclose that it expects an adverse opinion from its auditor (PricewaterhouseCoopers) on its internal controls. This morning, Visteon joined ranks with it - right down to the same auditor.

Visteon released an 8-K detailing its expected restatement of 2002, 2003, and the first three quarters of 2004. The restatement is due to a potpourri of changes: a switch in inventory accounting from LIFO to FIFO; an adjustment to deferred taxes for the effects of currency fluctuations on retained earnings of foreign subsidiaries, triggered by plans to repatriate earnings; deferred tax valuation allowance adjustments; and a reversal of reductions in postretirement life and health care costs.

It's that last one that's the most interesting. It seems that Visteon had modified the terms of its OPEB plans in the US and the changes in benefits had not been properly communicated to the employees under Statement 106 - and that means they couldn't go ahead and account for the reductions in benefit expense that they took in 2002, 2003 and the first nine months of 2004. The restatement will reverse those $88 million of cumulative pre-tax cost decrements. (There's a deferred tax effect to the reversal as well, perhaps as much as $54 million. It's not completely clear from the 8-K if some of that amount relates to the inventory methodology switch.)

The communications snafu cost Visteon a shot at getting off to a good start on its Section 404 reporting: management concludes that the lapse of communication constitutes a material weakness in internal controls, and they will not be able to conclude that said internal controls are effective as of December 21, 2004 (the only day that matters.) The firm's management expects to receive an adverse opinion on its internal controls from auditor PwC - just like Eastman Kodak.

If Sam DiPiazza is right, they'll have plenty of company. Soon.

In the past couple years, companies have been required to disclose the accounting policies that they consider to be most "critical" in terms of the effects they have on earnings or are most subject to a high degree of estimation. In surveying the S&P 500 the past couple of years, I've noticed one common policy/estimate termed critical by many companies: self-insurance estimates. In and of itself, that's not worrisome: investors should understand that it's a fact of life, a necessity in dealing with workmen's compensation liability, expected legal settlements and the like. The troubling aspect of it is that any discussion of these policy/estimates ends right there. No numbers, no further details available: sorry, nobody required us to do that.

Last March 15, the Wall Street Journal ran a story on Goodyear's restatement of earnings from 1999 to 2003, due in part to an understatement of "workers' compensation claims accruals at a single U.S. plant." (If you want the story, you have to pay for it. Key in on the headline "Outside Audit: The Red Flag Called 'Self Insurance' Goodyear's Restatement Is Warning for Investors" by Theo Francis & Timothy Aeppel.)

It now looks like Goodyear isn't the only company in a scrape over such accruals, according to the WSJ. Here's an excerpt from Interstate Bakeries' 8-K filed today:

"Interstate Bakeries Corporation (OTC: IBCIQ.PK) today announced that the Securities and Exchange Commission (SEC) has issued a formal order of private investigation into issues that were the subject of a previously announced informal inquiry by the SEC. The formal investigation appears to concern matters related to a previously announced investigation by the Company's audit committee into the Company's manner for setting its workers' compensation reserves and other reserves."

As you peruse the upcoming annual reports, it would be wise to keep your thinking sharp and critical when you're dealing with labor-intensive companies making workers' comp accruals. If a firm can't do more than mention them and other "self-insurance accruals" as mere boilerplate MD&A disclosures, are they really being forthright with their shareholders? And if they're not - what's going on in those accounts?

In the last few years, there's a condition that's afflicted many analysts and investors: its acronym is PDHD, standing for "Pension Deficit Hyperactivity Disorder." Those afflicted with it often foam at the mouth, moaning loudly and frequently upon realizing that firms they're interested in might be forced to fork over cash to fund underfunded defined benefit pension plans. It's a serious condition for both the firm and its investors.

Do not confuse this condition with PPHD: Padded Pension Hyperactivity Disorder. The symptoms are similar - foamy oral orifice, loud moaning - but you must pay attention to the moaned message to distinguish PPHD from PDHD. With PPHD, investors and analysts find themselves out of sorts because a firm has an overfunded pension plan that contributes non-cash earnings in the consolidated earnings picture, and more commonly, are concerned about the effects of cheery pension asset earnings assumptions on consolidated earnings.

(I speak from experience: I've had both. I've always handled it by spending more time with stock option disclosures. But that leads to other conditions, whose symptoms can be worse.)

Investors and analysts afflicted with these conditions are not necessarily hypochondriacs. And now, there's some solid empirical evidence that those afflicted with PPHD are really fairly accurate in their perceptions of the world.

It's not light reading, but if you suffer from PPHD, it's worth downloading "Earnings Manipulation, Pension Assumptions and Managerial Investment Decisions." Authored by Daniel Bergstresser, Mihir Desai, (both of Harvard) and Josua Rauh (MIT), the study shows that:

"Managers appear to manipulate firm earnings when they characterize pension assets to capital markets and alter investment decisions to justify, and capitalize on, these manipulations. Managers are more aggressive with assumed long-term rates of return when their assumptions have a greater impact on reported earnings. Managers also increase assumed rates of return as they prepare to acquire other firms and as they exercise stock options, further confirming the opportunistic nature of these increases ... Taken together, these results suggest that opportunistic earnings manipulation influences significant managerial investment decisions." (From the abstract)

The methodology is perhaps more than you'd care to hack through - but suffice it to say, it was not based on a spurious selection of limited data. There was interesting focus on IBM during the Lou Gerstner years in the paper, as well.

The author's findings should at least make those suffering from PPHD confident that the problem is not all in their heads.

(A disclosure first: I own shares of EK, and so do my asset management clients. End of disclosure.)

Eastman Kodak released its fourth quarter earnings yesterday, and released something else as well: news that it has internal control issues and will receive an adverse opinion from auditors PricewaterhouseCoopers on said controls. (Maybe this is what Sam DiPiazza had on his mind in Davos yesterday.)

This is the first forecast I've seen from a major firm about the content and tone of their forthcoming internal control review report. Investors are naturally curious about what dark secrets, if any, these reports may reveal and how the stock market will react. Let's see what we can parse out of the news of this “early discloser.” (Don't get your hopes up.)

From this first glimpse, it's hard to tell much: Kodak shares closed 11 cents higher on the day of the announcement -leading one to perhaps believe the market has a “so what?” attitude on internal control weaknesses. But the company also released fairly upbeat news about its foray into digital photography; that bit of news might have had more of an effect on stock prices than the internal controls announcement.

What about the nature of the internal control weakness? Read the 8-K excerpt below, quoting Robert Brust, Kodak's CFO:

"Remember that Kodak has been devoting significant resources for more than a year to assessing, and strengthening as appropriate, its controls in the context of its Sarbanes-Oxley Section 404 review," Brust said. "This situation arises from tax accounting errors, not misconduct. It involves complex tax rules, in many cases relating to our restructuring actions overseas, that vary by country.

"Kodak's management, in conjunction with external consultants, is currently analyzing its income tax accounts, and adjustments may result from this review," Brust said. "We are moving as quickly as we can to take appropriate corrective action, and we are keeping the Audit Committee of the company's Board of Directors fully informed. We expect to complete the work during the next six weeks, at which time we will issue final results for the fourth quarter and for the year."

As a result of the income tax accounting errors, the company has determined that it has an internal control deficiency that constitutes a "material weakness," as defined by the Public Company Accounting Oversight Board's Auditing Standard No. 2. Consequently, management will be unable to conclude that the company's internal controls over financial reporting are effective as of Dec. 31, 2004. Therefore, PricewaterhouseCoopers will issue an adverse opinion with respect to the company's internal controls over financial reporting. An assessment of the company's internal controls will be included in its Annual Report on Form 10-K, which will be filed in March.

From the sound of it, there isn't malfeasance, theft or cash involved - and maybe if there had been, there would have been a more negative stock price reaction, one that overpowered the digital photography “good news. “

My guess on the reactions to these disclosures: the nature of the weaknesses and flaws giving rise to an adverse opinion will be what matters most - and the earnestness with which a firm will attack its described problems. Internal control weaknesses over cash or those relating to profound earnings impacts, will likely be viewed most fearfully by the market. And companies that beat around the bush, giving only vague reasons about the nature of the audit opinion, will probably see their stock prices suffer the most.

There's bound to be more and more news about the Sarbanes-Oxley Section 404 internal control reviews as the first-ever reporting period looms. Some of the more intriguing stories today:

- At the World Economic Summit in Davos, Switzerland, PricewaterhouseCoopers Chief Executive Sam DiPiazza hazarded his guess that 10% of U.S. companies will either report that they couldn't complete the review in time for their 2004 annual report, or found internal control weaknesses. (WSJ link here.)

- In a speech delivered at the London School of Economics yesterday, SEC Chairman Bill Donaldson announced that he has asked the Commission staff to consider delaying the internal control reporting requirements for non-US filers.

- Finally, an item with a Sarbanes-Oxley flavor, but not related to Section 404 reports: the American Enterprise Institute issued a white paper recommending that the Public Company Accounting Oversight Board be folded into the SEC within five years.

There's a Sarbanes-Oxley backlash movement building; expect to see more of this kind of thinking emerge.

As reported by Business Week Online, SEC Chief Accountant Don Nicolaisen outlined his hopes for simplification of accounting standards at a New York Society of CPAs conference yesterday. (No link to the speech from the SEC's website is available yet; to be added when available.)

Nicolaisen touched on the use of XBRL, a technology that might revolutionize the way investors access and use the SEC's EDGAR database; support for more “principles-based” accounting standards; and he mentioned the Commission is looking at simplifying accounting such as “by segregating operating income from companies' other income streams”, and is looking at ways to simplify some revenue recognition issues and accounting for derivatives.

He also hinted that more breaks might come the way of smaller companies who have been complaining that Sarbanes-Oxley has caused them undue pain.

(Not my favorite idea. I think that one reason companies have had so much trouble dealing with the internal control reviews required by Sarbanes-Oxley is that they've become ossified in the way they do things, and shaking them up in a re-examination of how their accounting processes might be improved is naturally going to be painful, disruptive and costly. It's probably especially painful because companies traditionally view the accounting and finance function as cost centers incapable of producing something other than compliance with SEC and tax reporting, and therefore, they're functions that are something to be minimized. Anyway - give young companies too much “relief” from having to comply with Sarbanes-Oxley strictures, and you just might get companies that grow up with underinvested accounting systems and controls. Again.)

One point the article mentioned, and I excerpt it here:

“How do you transform today's accounting regulations (with 800 pages devoted to derivatives accounting alone) into a code as simply functional as an alarm clock?”

Just wanted to weigh in on that “800 pages devoted to derivatives” comment. Statement 133 is the whipping boy for accounting standard complexity, and it's not hard to see why: 800 pages is a lot of meat. Or fat, depending on your point of view. But if anyone wants simpler standards, look at Statement 133 for lessons on how to simplify.

That's right - simplify. As much as it's vilified for its complexity and length, it's that way because of the exceptions allowed to the basic premise of the standard, which was that derivatives must be reported on the balance sheet at their fair value. The standard itself is only 50 pages long - not exactly a comic book, but about half of that is devoted to the principles of “hedge accounting” - which are accounting treatments that companies are allowed to use for dampening the effects of reporting derivatives at fair value. Most of the rest of the standard is devoted to “implementation issues” for which companies petitioned the FASB.

So, the next time you hear the “800 pages devoted to derivatives” cliche, think of what it could be - maybe only a fraction of that - if companies weren't so dead set on avoiding the reporting of volatility. (See also: Fannie Mae, filed in the “Smooth Earnings Zone.”)

But it doesn't really need to be; it's got plenty of cops 'n robbers entertainment value just the way it is.

The Wall Street Journal reports today that Penthouse publisher Robert Guccione, along with a former executive officer and a former shareholder, were charged with accounting fraud by the SEC.

The details are sketchy, but they carry the aroma of early revenue recognition. It sounds as if there was a contract that was pulled into the March 2003 quarter, earlier than it should have been: the article says the misleading information revolved around a backdated document. Further, according to the SEC, Guccione certified a filing that he hadn't reviewed. The net result: inflated results for the March quarter.

Over the next six months, I believe that we'll be seeing a flood of companies using the "accelerated vesting of options" shtick to void much of Statement 123(Revised)'s impact on earnings.

Would such transactions have ever been devised if Statement 123(Revised) didn't come to pass? I sincerely doubt it. If they are so necessary to "incentivize" personnel, why didn't these kinds of transactions occur before Statement 123(Revised) was released?

In terms of reporting financial events, the notices of material modifications to contracts given by the following companies in their 8-Ks and 10-Qs are the reporting of transactions that have been undertaken by them most likey in order to avoid reporting of other financial events (granting of stock options as compensation.)

What a system!

The list will (hopefully) be updated on an occasional basis, as time permits. Counted so far: 30 companies.

    The List:

Applera Corp.
Brooks Automation
Cabot Microelectronics
Cellu Tissue Holdings
Cooper Cameron
Dow Jones
Encore Medical
E-Z Em Inc.
Greg Manning Auctions Inc.
ICU Medical
Infocus Corp.
Linear Technology Corp.
LKQ Corp
Martek Biosciences Corp.
MKS Instruments
PSS World Medical
Radisys Corp.
Sonic Innovations
Waters Corp.
Wisconsin Electric Power
* Shares owned by the author, members of his family, and asset management clients of R.G. Associates, Inc.

CFO.com cites an interesting figure, from the folks at Compliance Week, who track such things: there have been 582 reports of internal control weaknesses or deficiencies in 2004 - compared to 14 in 2003. One hundred ninety-nine of the disclosures were made in just one month - November - with another 56 in December.

There's plenty of rank speculation in the investment community about just what will happen to the stock prices of firms who get something less than a clean opinion on their internal control systems as a result of this year's "Section 404" audits. It sounds like there are at least 582 candidates who might find out for sure if they don't get their house in order.

There's a publicly-traded consulting firm out of Chicago by the name of Huron Consulting Group (ticker HURN) with an interesting heritage: it started life in 2002, founded by a group of mostly ex-Arthur Andersen partners and consultants.

For the last couple of years they've produced an excellent annual study of restatements of financial statements - no shortage irony, there. You can find the 2003 report here. The complete study for 2004 is not yet available, but they've released their summary of findings.And the results are interesting, and they perhaps bear on the current flap over Sarbanes-Oxley.

The report shows that financial restatements (tracked by year filed), rose to 414 in 2004 from 323 in 2003 - a 28% increase. Over 16% of the restatements related to improper revenue recognition; another 16% were related to equity issues: things like stock option accounting and EPS accounting. Over 14% were tied to valuation reserves (for instance, allowance for doubtful accounts, and inventory reserves) along with restructuring and other accruals.

Why the big increase? It may have something to do with the Section 404 internal control reviews, though not directly. We've all been hearing stories of firms crawling with auditors, looking at internal control systems. In their reviews of internal controls, auditors may have become aware that their past understandings of a clients's internal controls were not as good as they thought, and may have uncovered misstatements they should have caught in past years. Or they may be finding errors as they do preliminary year end work in conjunction with their internal control reviews, and insist that their clients restate where possible. Given the higher stakes, auditors may simply be less tolerant of any misstatements than they used to be.

Put simply, the increased auditor activity may have something to do with the restatement increase. Next year, once the pain of dealing with reinvigorated auditors is past, the rush to restate rush might diminish.