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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.

A friend forwarded this excerpt from Monarch Casino & Resort's 10-K. The registrant is a "non-accelerated" filer, meaning they've got until the end of 2006 to get their internal controls in order for being reported upon. But they sure don't sound happy about it:

[I underlined the best parts.]

"There has been no change in our internal controls over financial reporting during the year ended December 31, 2004 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reports.

We are in the process of our compliance efforts mandated by Section 404 of the Sarbanes-Oxley Act of 2002. As we have done our due diligence in trying to understand the requirements and corresponding work necessary to successfully document our system of internal controls to the standards and satisfaction of third parties, we have encountered egregious estimates of time, dollars, outside consultant fees, and volumes of paperwork. As our implementation has progressed, we have yet to realize any control, operations or governance improvements or benefits. Additionally, and most importantly, the estimated potential cost to our shareholders in relation to the benefits, or even potential benefits, is unconscionable. We believe that these additional costs and expenses will merely confirm the existence of an already effective and functioning control system that already conforms with a recognized system of internal controls.

Although we intend to diligently pursue implementation and compliance with the Section 404 requirements, we do not believe it is in our shareholders' best interests to incur unnecessary outsized costs in this effort. As we are a single location company with an extremely involved, hands-on senior management group in a highly regulated industry with significant insider ownership, the potential benefits to be derived from the Section 404 requirements are believed to be minimal. Consequently, we will make every effort internally to comply with the Section 404 requirements but will minimize what we believe to be the unreasonable and unnecessary expense of retaining outside third parties to assist in this effort.

As a result of this cautioned approach and the complexity of compliance, there is a risk that, notwithstanding the best efforts of our management group, we may fail to adopt sufficient internal controls over financial reporting that are in compliance with the Section 404 requirements."

Right now, they're a $180 million market cap firm, but it's doubtful that they want to stay a small-cap outfit. Let's see where they are in two years when they actually have to report under Section 404. Maybe their perspective will change as they grow. In the meantime, you've got to wonder: if their controls are so effective and wonderful, why is it so hard to be in compliance with Section 404? That's a question for all the small firms protesting 404 but claim to have sufficient controls, anyway.

That's the question to be asked. (And it has been asked - many times.) If anywhere, I think it could occur in the industrial, health care and information technology sectors. But I don't have a strong conviction that it must happen. Let me explain why. Think about the nature of the restatements: the three kinds of leasing errors described in the SEC's February 7 letter to the AICPA run the best chance of occurring in industries where 1) there are leasehold improvement on top of the property being leased, 2) there can be concessions from the landlord to the lessee for the cost of leasehold improvements and 3) there may be a rent payment schedule that differs from the straight-line recognition of rent expense. The industries that have been most affected by the restatement blitz have been the restaurant and retail industries, and to a lesser degree, the (wireless) cellular tower companies. If there are three trip wires to trigger a lease accounting restatement, these industries face the best chance of stumbling on at least one of them. They're asset-intensive businesses, often financed by operating leases; but more frequently than other industries, they have leasehold improvements on top of property leased. That's not as common in other industries that make use of operating leases. For instance, airlines are notorious for using operating leases for aircraft - but they don't have leasehold improvements to the airplanes. Likewise, hospitals lease plenty of heavy medical equipment - but you don't see leasehold improvements stuck onto an MRI unit. Retailers, restaurants and cell tower companies are a bit unique this way - they lease real property, and put something on top of it. That increases their chances of getting their lease accounting wrong. I know, I know - I've pointed out a few strays from time to time. Like Heritage Commerce Corporation, Powell Industries and Siebel Systems. Like everyone else, I've been curious to see how widespread this trend could become, and stayed alert for the unusual restaters. Now I think these firms were simply outliers and not harbingers of new trends. We did a little screening with the S&P Research Insight database to see what other industries might be affected. For all the firms on the NYSE, ASE and NASDAQ, the annual rental expense (for operating leases) in the most recent year was multiplied by a factor of 8 - an old standby rule of thumb for estimating the "buried-debt effect" of operating leases on a firm's balance sheet. Then the result was divided by each firm's total assets to see the significance of off-balance sheet operating assets to the firm's asset base. The higher the result, the more dependent would be the firm on its off-balance sheet assets - and the more likely it would have multiple lease contracts, increasing its vulnerability to a lease accounting restatement. The results: there were 251 firms in the universe where the "8x rentals" amounted to 50% or more of the firm's total assets. Below, the breakdown by sector: 8x Rents/Assets (Avg.) No. of Firms Materials 189% 3 Consumer Discretionary 130% 99 Industrials 108% 39 Telecommunication Services 100% 7 Health Care 89% 37 Information Technology 82% 55 Financials 72% 5 Consumer Staples 67% 5 Energy 62% 1 251 [Yes, I am HTML-challenged. We'll both have to live with it.] While the materials sector showed promise in terms of lease-dependency, notice it was filled with only three companies - put them in the outlier category and not trend-setters. The consumer discretionary sector pretty much confirms that the test was a good one. Why? Because 59 of the firms were retailers, and another 28 were restaurants - where most of the action has been, so far. The category made up nearly 40% of all the results, the single biggest presence in the results. The industrials, health care, and information technology sectors all showed significant lease-dependence and were broadly represented in their sectors. That suggests that lease restatements could occur in those sectors as well - but do the kinds of property they lease contain the three trip wires that have been present in the restaurant, retail and cell tower industries? There's no way to tell from this test: the dollar amount of rental expense doesn't say much about the nature of the assets being leased. The "rent escalation" issue could occur in just about any kind of lease, any industry. But if it's the only lease foul-up that a company finds, it might not be material enough for 'fessing up. If the other two trip wires are present, it increases the chances of a mea culpa because there are more opportunities for dollar amounts of errors to cross the threshold of materiality. The players in the industrials, health care, and information technology sectors don't set off my bells as being big users of real property with improvements stacked on it - but if there are firms within those sectors that fit that prescription, we could see lease restatements in those groups. If all their leases pertain to discrete equipment, with only exposure to the rent escalation issue, the probability of lease restatements decreases. So there you have it: plenty of leasing going on in those sectors, but not necessarily of the kind generating restatements so far. If we start seeing...

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The SEC's planned roundtable on Section 404 was mentioned in this weblog a few weeks ago. The date of the roundtable is April 13. The Commission has solicited comments from all interested parties about their experiences and impressions of the first Section 404 experience.

Being an interested party, I submitted my thoughts. Here's a link if you're interested.

As noted previously, the SEC's Office of the Chief Accountant released Staff Accounting Bulletin No. 107 regarding FASB Statement No. 123 (Revised). It's a good faith effort by the SEC to address the concerns of registrants who are perhaps flummoxed by the new accounting standard; in fact, it reads like a "Frequently Asked Questions" document. Plenty of topics within the topic of share-based payment, filled with questions and fact patterns that registrants should be able to adapt to their own circumstances.

[One oddity: the SAB contains over 13 pages of discussion on computing the volatility input for option pricing models. This is a concern now? What were companies doing when they were computing volatility inputs for making the Statement 123 pro forma footnote disclosures over the last nine years - using a ouija board? Or the random number generator function in Excel? It makes you think those professors looking at the quality of footnote information were really on to something.]

The guidance offered extends to the questions about the possible next wave of pro forma reporting - how to handle Statement 123 expense in press releases. (Yes, it can be pro forma'ed away in press releases if it reconciles to the GAAP figures. No, firms cannot do the same in SEC filings.) Within 8 pages of guidance on estimating the expected life of options, the document even offers a shortcut that the Commission will allow when it comes to calculating the expected life: firms will be permitted to take the average of the vesting period and the contractual option life to determine the expected life. (Can't see why that's a real answer. And there's that nagging question again: what were companies doing when they were computing expected life inputs for making the Statement 123 pro forma footnote disclosures over the last nine years?)

The document doesn't break new ground; it's very much keyed in to Statement No. 123(Revised) itself, not a refutation of the document. You could call it "Frequently Asked Questions About Statement No. 123 (Revised) instead of SAB No. 107.

And that's why these guys are unhappy. And these guys. And these guys. (That's more redundant than it sounds. The AeA and the Semiconductor Industry Association are both trade members of the International Employee Stock Options Coalition. Instead of one voice, it's more of a three-part harmony of invective directed at the SEC for not damaging the new accounting standard.)

The International Employee Stock Options Coalition griped that "Given the more than 60 pages of very technical and complex guidance, we believe the June 15, 2005 deadline for implementation remains unworkable. On top of the extensive responsibilities and obligations imposed by Sarbanes-Oxley that remain ongoing, we believe that good policy and common sense warrant a delay in the implementation date."

Again: much of the document relates to issues that companies should have had a handle on for nine years. The document is not breaking new ground. Complaints like these are nothing more than a continuation of the high-tech's stall strategy - while they wait for friendly legislation to be acted upon in Congress. (Friendly legislation to them, that is. Which would be very investor-unfriendly.)

It's here - the SEC's long-awaited Staff Accounting Bulletin on implementing Statement 123(Revised).

No time at the present to review it, will do so later - but I thought you might want to take a look at it yourself first.

It's annual report season: hopefully you're one of the studious types that actually reads 'em cover to cover, with emphasis on the footnotes because it's the only time of the year they're actually filled with information.

Uh-oh. There's this disturbing story in the Wall Street Journal: "Study Finds Errors In Footnotes Less Likely To Get Fixed." It seems a trio of enterprising professors from Cornell University and Bentley College tested auditors' reactions to discovering errors in footnotes as opposed to errors embedded in financial statement figures. An excerpt:

"In one experiment, auditors were asked how they would handle a company that had underestimated the cost of employee stock options, but objected to making any adjustment. Some auditors were told the firm included the cost of stock options on its income statement; others were told the cost was shown only in a footnote.

Even though the size of the error was the same in both cases, amounting to about 4.6% of net income, auditors had very different reactions. When the error was on the books, auditors called for a full or nearly full correction on average. When the error was in the footnote, the auditors rarely called for any correction."

As we trudge toward recognition of stock compensation recognition in the second half of this year, this study has to make you wonder about the quality of the "pro forma" Statement 123 information contained in the footnotes since 1996.

If you missed "We've Been Listening", don't. It's SEC Chairman Bill Donaldson's Wall Street Journal editorial about the Section 404 internal control reviews and the hue and cry over them. Read it in full, but let me print one excerpt:

"I believe, however, that the voices calling for a roll back of portions of Sarbanes-Oxley, citing Section 404 as the poster child for over-regulation, are short-sighted. The principles behind the Act are unassailable and action was long overdue. Furthermore, the initial implementation of Section 404 has, by and large, been successful. The time, energy and expense that companies are now investing in their internal controls will, I predict, earn a handsome return for years to come."

I couldn't agree with him more.

Associate Melissa Herboldsheimer turned up this tidbit from compensation consultants Pearl Meyer & Partners: a list of "10 Critical Steps Companies Should Take Today" to meet the pending implementation of Statement 123 (Revised).

Hello? It's March 29 - and firms should just now be figuring out the critical steps in implementing Statement 123 (Revised) in three more months? Section 404 reviews have certainly been a distraction, but interested parties should have seen this train coming for years.

The checklist is an excellent blueprint, for sure: chock full of detailed steps that every controller, CFO and HR honcho should have hashed out together many months ago, unless they were in full denial mode. And some of them are creepy but expected, in terms of earnings gamesmanship: "Build Your Case: Develop Assumptions -- Determine what works best for your company" and "Size the Problem: Projecting Your Expense/Dilution" kind of say it all.

Pearl Meyer is in the business of planning compensation plans: if they're issuing this kind of business-generating advice now, I'm wondering if it means they know just how unprepared firms really are. Any CFO who prints a copy of this checklist and starts worrying now should perhaps check this link and recite the creed. After all, there's still a full three months before the standard goes into effect.

The Wall Street Journal ran a story this morning that's sure to make an impression on anyone curious about high fast audit fees will rise in the wake of Sarbanes-Oxley Act compliance. A study of 23 firms in the Dow Jones Industrials - some of the largest companies trading in the stock markets - showed that their audit fees rose about 40% to $533 million. That's sure to make an impression. But that's on 23 of the largest firms - not exactly the stuff to draw conclusions from about the greater population. So - I wandered into the R.G. Associates data warehouse, poking around for some stuff I knew we had on audit fees. I found an audit fee file we'd started that contained 103 companies not in the Dow Jones Industrials - maybe a fairer sample from which to draw inferences. (Note: it's preliminary data, and not likely to be updated here in the weblog. It's part of a larger project to be made available at a later date to subscribers of The Analyst's Accounting Observer.) It's a bit mixy to just look at the audit fees alone - there's no clear definition of what firms parse out of it and put into "audit-related" fees. Some firms include quarterly reviews in audit fees, for instance, and some include them in audit-related fees. So, to be on the safe side, we combined them for 2004 and 2003 to get an idea of how much fees have changed in one year. The change in total audit fees for the 103 non-DJIA companies? 23.3%. (If you looked at the straight audit fee figure alone, it wasn't much different: 24.4%.) A pretty far cry from 40% - but even if it was 40% for all the firms, it would still make sense. If auditing firms have skinnied down their fees for years, making up for it with consulting fees later, and they're now compelled to do more nitty-gritty auditing work - how can you expect them to do it for free? A prickly, viable auditing profession is necessary for the well-being of investors and capital markets, and paying them well for services is one way to ensure their ability to recruit future auditors. Table below; dollars in millions. Forgive the appearance, but this HTML stuff is taking time to get. 2004 Audit Fees 2004 Audit-related Fees Total % Chg. 2003 Total Air Products & Chemicals $3.80 $0.50 $4.30 2.4% 4.20 Alberto-Culver 1.97 0.08 2.06 4.9% 1.96 Apollo Group 0.48 0.06 0.54 45.2% 0.37 Amerisourcebergen 2.11 0.29 2.40 -12.9% 2.76 Applied Materials 2.55 0.13 2.68 94.8% 1.38 Analog Devices 1.53 0.21 1.74 6.8% 1.63 Archer-Daniels-Midland 7.31 0.20 7.51 48.3% 5.07 Agilent Technologies 4.59 0.17 4.76 6.7% 4.46 Andrew 1.78 0.12 1.90 5.9% 1.79 Automatic Data Processing 4.61 3.56 8.17 33.3% 6.13 Autozone 0.62 0.01 0.63 12.5% 0.56 Applera 1.92 0.30 2.22 5.5% 2.10 Becton Dickinson 3.93 0.10 4.03 17.7% 3.42 Best Buy 1.01 0.17 1.18 58.1% 0.75 Biomet 1.19 0.08 1.27 1.6% 1.25 Applied Micro Circuits 0.22 0.10 0.33 -4.7% 0.35 Bmc Software 3.65 0.04 3.68 44.8% 2.54 Brown-Forman 0.99 0.62 1.61 39.2% 1.16 Campbell Soup 2.39 0.12 2.51 26.3% 1.98 Cardinal Health 8.02 2.93 10.94 56.5% 6.99 Ashland 5.32 0.15 5.47 8.0% 5.06 Autodesk 1.65 0.00 1.65 16.0% 1.43 Ciena 0.62 0.14 0.76 5.7% 0.72 Cintas 0.29 0.11 0.40 -32.4% 0.60 Circuit City Stores 0.64 0.40 1.04 14.0% 0.92 Cisco Systems 3.90 6.40 10.30 191.5% 3.54 Clorox 2.36 0.28 2.64 -7.7% 2.86 Coach 0.62 0.24 0.86 47.5% 0.58 Avaya 3.70 5.00 8.70 85.4% 4.69 Computer Sciences 4.69 1.39 6.08 13.3% 5.37 Compuware 1.11 0.04 1.15 40.8% 0.82 Conagra Foods 4.08 1.36 5.44 -4.4% 5.69 Costco Wholesale 1.11 0.40 1.50 63.6% 0.92 Darden Restaurants 0.40 0.04 0.44 -13.9% 0.51 Deere 7.20 1.00 8.20 18.8% 6.90 Dell 3.90 1.20 5.10 15.9% 4.40 Affiliated Comp Svcs. 0.86 0.61 1.47 66.2% 0.88 Block, H & R 2.12 0.94 3.07 71.4% 1.79 Emerson Electric 11.10 2.50 13.60 5.4% 12.90 Family Dollar Stores 0.19 0.04 0.23 13.0% 0.20 FedEx 7.33 0.37 7.70 21.9% 6.32 Forest Laboratories 0.65...

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The Wall Street Journal reports this morning that the SEC is nearing completion of its guidance on implementation of the FASB's new standard on stock compensation accounting, Statement 123 (Revised).

It'll be interesting to see the final result. I'm trying not to pre-judge, but I'm curious to see the level of guidance given in this thing - and how much of it was really necessary versus how much of it is mere hand-holding to answer the cries of a petulant bunch of option-expensing opponents.

The guidance wasn't necessary for the hundreds of companies that have already adopted fair value accounting for stock option compensation. Does that mean they adopted it incorrectly? Or that the ones that didn't adopt because they wanted "guidance" are just more accounting-challenged?