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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.

Guest editorialist Walter P. Schuetze put his thoughts to paper in this weekend's Barron's (subscription required) and made a number of useful points. I've known Walter for a number of years and I think highly of him and his opinions. He's got quite a resume, including stints as a FASB board member and the SEC's chief accountant. I can't say I agree with everything in his editorial, however. Walter's complaint - and a good one at that - is that financial statements aren't as reliable as other familiar items. The power tool that you plug into the wall isn't going to electrocute you because the manufacturer has lived up to Underwriters' Laboratory standards. Kellogg's corn flakes are safe to eat because they've been around for years and presumably, they haven't harmed anyone yet. In short, most products are fit for intended use. Except financial statements. Walter believes that financial statements are far too wedded to historical cost rather than reflecting fair values of assets and liabilities. True enough, and I agree with that premise - but up to a point. Walter bemoans the fact that there are "surprise, elephant-size write-offs of accounts receivable, loans receivable, inventory, fixed assets, deferred tax assets (does anybody other than an FASB accountant know what a deferred tax asset is?), and goodwill that follow earnings management like a dog follows its master, and the huge declines in the market prices of the stock of the reporting corporations that follow write-offs like a tail follows the dog." Sure, there are write-offs. Those write-offs should occur when something has happened to change their value; when there's an impairment to an asset, a charge (writedown) ought to happen immediately. It's part of making the financial statements show what assets are worth - bringing them closer to fair value - and showing what happened in a given period. The fact that the writedowns have occurred doesn't mean financial reporting isn't doing the job it's intended to do - the real question might be why they don't occur sooner. Where I think my view differs from Walter's the most is in this passage: "... today's financial statements and reports are so complex and arcane as to be incomprehensible. Beyond lack of clarity, financial statements and reports as we know them today affirmatively mislead investors, who are their consumers. Such financial statements and reports are not "fit for their intended use." Retail investors do not understand today's financial statements and reports, which are based on generally accepted accounting principles issued by the Financial Accounting Standards Board. Nor do many institutional investors. Nor do men and women in Congress, which became obvious during the congressional hearings about Enron and WorldCom a couple of years ago. What they do not understand, they cannot use." I do not believe for one moment that "today's financial statements and reports are so complex and arcane as to be incomprehensible." I believe that the transactions in which firms engage themselves are indeed complex and border on the incomprehensible and that is what financial reporting is reporting. Don't confuse the messenger with the message. Can the message in the financial statements be sorted out? Yes, by those willing to invest the time and effort to do so. And that's the way capitalism works: you want the rewards, you put in the effort. Should "retail investors ... understand today's financial statements and reports?" If they're willing to put in the effort to understand them, yes. Should financial statements and reports of complex organizations involved with complex transactions be transformed into something they really aren't ("Financial Statements for Dummies?") just to find a lowest common denominator? I don't think so; I don't think that's making financial statements tell the true story. I sometimes wish I'd been a brain surgeon, but the coursework was too hard. (So I became an accounting analyst.) Should brain surgery be easier to accommodate guys like me? I don't think so. But if I ever need a brain doc, I'll find one who completed his schooling. (I know, I know: go see one now.) If retail investors can't understand financial statements, then they should find a broker or mutual fund they trust. Do investment professionals really understand the financials? Sometimes. Is it the fault of the financial reporting system? I don't think so. I think there's a real aversion in most people in getting down to detail work, and that's what digging through financial statements is all about. You find that you don't "get" everything the first time you encounter it, you feel dumb, and you don't always want to doubt your capacities. Some folks dust themselves off and make themselves find out what they don't know. I think the vast majority find it easier to slough the work and say that the accounting isn't important because it's all backward-looking or it's already in the price of the stock because everyone else read it or interest rate changes are far more important or accounting is the province of geeks. Or some other excuse. A lot of this is ingrained into investment professionals' thinking as they go through B-school; we're just not brought up to believe that accounting and financial statements are terribly important. Better to diversify, so you don't wind up getting hit too hard should one of the companies you own bomb out. (It's funny how diligently some people will study financial statements after that's happened.) I digress. Back to Walter's editorial. Walter suggests that "financial statement numbers be based on market values prepared by independent experts who know about markets and market prices." Auditors would attest to accounting, and leave the valuation stuff to experts. No management control over valuation issues. Sounds good at first. Think...

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It's the Freddy Krueger of restatement stories: "Nightmare On Software Street." The thing refuses to die.

Yesterday, Computer Associates filed a non-reliance 8-K on its 2001 and 2000 financial statements. They'd already been restated in April 2004 because of revenue recognition flaws. And now there are more, it seems: CA has found additional improper transactions in the years 1998 through 2001.

Some of them were "contemporaneous purchases and sales (or investments and licenses) of software products and services with the same or related third parties... [apparently] not ...negotiated on an arm's-length basis and [having] no valid commercial purpose." In short, they made themselves look bigger than they were by arranging sales for the sake of sales that contained no profit. It sounds like the website advertising game played in the mid-1990's where firms would sell each other advertising with no profits in them, just for the sake of making revenues look better.

Thought: if your local supermarket injected its turkeys with water to make them look plumper, wouldn't you be incensed? Would you want to pay for the water weight? How different from that scam are these kinds of deals?

While the transactions originated in 1998 through 2001, the accounting treatment has flow-through effects in the following years - all the way up to 2005. The company says the "impact on revenue and net income (loss) in subsequent periods is relatively small" and will restate its financial statements for fiscal years 2002 through 2004, as well as make adjustments in 2005 figures. Coming to EDGAR this summer.

Another day, another inventory goof...

A couple days ago, I mentioned the Maxtor slip-up on its inventory reporting in the first quarter. I made the case that it wouldn't be surprising to see more goofs along the lines of Maxtor's. But I didn't expect to see one quite so similar and quite so soon.

Yesterday afternoon, Longview Fibre Company filed an 8-K for its second quarter earnings - and simultaneously filed another non-reliance 8-K in which the firm advised investors not to rely on its first quarter figures due to an error in figuring its LIFO inventory valuation. It'll be filing an amended 10-Q soon.

LIFO inventory calculations are painful exercises involving indexes that are often internally-constructed by firms; the indexes are applied to layers of purchases to arrive at a LIFO value. In Longview's slip-up, an index from last year was mistakenly used in the current year calculation. Longview and its auditors consider the error to be evidence of a material weakness in internal controls.

Such restatements and discoveries are likely to be more commonplace, as I mentioned in the Maxtor posting. Investors need to develop an understanding of just what contributes to such errors and material weaknesses. The kinds of errors we've seen in these two instances occurrred in what might be considered isolated, occasional processes - ones that are performed only at say, quarter end and involving a lot of manual calculation and input. They're not at all like constantly recurring processes requiring good internal controls - say like, recognizing cash sales at a retail outlet. Because they happen only occasionally, and involve complex issues, it's more likely that human errors could affect these transactions. Another example of transactions like these: income tax calculations. While errors in these kinds of recordations aren't necessarily forgiveable, they're not reasons for investor panic attacks either.

This just in from the Public Company Accounting Oversight Board: they mean business.

Yesterday the PCAOB announced its first-ever "revocation of registration" of a firm - which means they cannot take on any audits of publicly-traded clients. One of its partners, Edward B. Morris, is barred from associating with a firm engaged in audits of publicly-traded companies. The firm in the PCAOB's cross-hairs: Goldstein and Morris, CPAs.


Goldstein and Morris, CPAs - possibly the only CPA firm in existence whose website is not yet complete. Observers and critics of the PCAOB will probably hoot at the punishment being meted out to such a tiny firm. After all, when one thinks of the PCAOB's task of policing the firms that audit the most significant publicly-traded firms, you think of the Big Four. Not Goldstein & Morris.

But if you look at the facts, they got what they deserved, I think. Public accounting firms are not permitted to perform bookkeeping services of audit clients; they'd effectively be auditing their own work. (A possible lack of objectivity, no?) Goldstein & Morris performed such services for two audit clients - New York Film Works and RTG Ventures - in violation of auditing standards. When the firm was notified that they were going to be inspected by the PCAOB, how did they respond? They worked on a plan to conceal the information requested by the PCAOB: creating and backdating documents and inserting them into audit files before the inspectors reviewed them. (Hey, it worked for Martha Stewart, didn't it?)

Two partners - Alan J. Goldberger and William A. Postelnik - resigned from the firm and informed the PCAOB of the deception. For their cooperation, they were censured by the PCAOB, a much more lenient treatment than was received by Morris.

It would be foolish to argue that the PCAOB should exist only harangue Big Four firms. Can you argue that we're a lot better off with only four instead of five big firms with Arthur Andersen in extinction?) Face it: they're policemen. They're supposed to enforce the law wherever they see it violated. A possible policing approach would be to pick the low-hanging violator fruit and make examples of the miscreants whenever they're found, to encourage compliance within the small and large firms. Their credibility will suffer though, if they've focused solely on small fry firms - and problems erupt later at the big ones.

Maxtor Corporation filed a non-reliance 8-K this morning, due to an error in recording quarter-end inventory last March. The error itself was a humbler: goods worth $2 million had been shipped FOB destination at the end of the quarter, meaning they belonged to Maxtor until they arrived at the customer's door. A journal entry had been properly set up to keep the goods in inventory, and out of cost of goods sold at period end - but the entry was inadvertantly reversed when it was recorded. The inventory was understated, and cost of goods sold was overstated.

How much? Inventory was understated by $4 million (1.8%); cost of goods sold was overstated by $4 million (0.4%). Not much of a balance sheet effect. But on the income statement, net loss was overstated by $4 million (16.7%) and the (ever-important) net loss per share was overstated by $0.02 per share (20%). In the rock 'n roll 90's, maybe that would have been shrugged off; maybe not. (Not that it would have been right.) But precision was definitely looser when it came to materiality.

As mentioned earlier, materiality is apparently being dialed down after the first round of internal control reviews - and when the SEC releases its new missive on materiality, it'd be reasonable to expect to see a lot more restatements. Need more evidence of increased precision in figuring materiality? Look no further than the SEC's comments on lease accounting and the restatements that ensued. Make no mistake about it: 2005 will set a record when it comes to sheer volume of restated financials. Sticking to standards and a narrower view of materiality are reasons why.

CFO.com reports that Marsh & McLennan Companies has filed an amended proxy statement that asks shareholders to approve a repricing of options.

The plan would exchange way out-of-the-money options for fewer new ones, issued at current prices.

According to the CFO.com story, the filing states that "This would help us to retain key staff, motivate and reward employees for their contributions to our future success and reduce a substantial amount of stock option overhang."

It's one thing - and a good one, at that - to try reducing the option overhang. But must it be done by a repricing of existing options? The stockholders who were around when the options were originally issued don't get to reprice their stock.

This, from the San Diego Union-Tribune: another tech company agrees with Cisco's idea to build a market for derivative instruments designed to mimic a value for employee stock options.

"It's a great idea that has the potential to bring some integrity to the valuation process," said William Keitel, Qualcomm's chief financial officer.

This is important for at least one reason: "integrity" is not a concept that tech firms have brought to the table when discussing stock option compensation. Ever.

As for being a "great idea," Coca-Cola's plan to have multiple investment bankers value its stock options as a way around using the Black-Scholes option pricing model was also heralded as a great idea. But don't forget that Coke scuttled the plan. According to accounting folklore, one of the reasons was that the investment bankers intended to estimate the value of the options using - you guessed it - the Black-Scholes option pricing model. Ultimately, the values derived from such hiring such expensive help would be no different than if the accounting staff plopped their estimates into a spreadsheet designed to do such calculations - so Coke scrapped the idea.

A couple days ago, Mr. Myron Scholes - that's his name in "Black-Scholes" - tossed some cold water on the Cisco system, questioning the genuineness of a market for these instruments - and wondering that "somewhere along the line the options [underlying the derivatives] would still need to be valued through an established options-pricing model." Just like Coca-Cola discovered.

Deja vu all over again. But this time it's different. (Maybe the five most dangerous words in the world.) This time, it's the tech companies are trying to present their version of reality and not some mild-mannered beverage maker. Intel made noises last week that it found the Cisco system "a pretty good idea;" now Qualcomm; and the Union-Tribune article quotes Dell's CFO as saying it's interesting. If the SEC buys off on the approach, the tech companies will bray loud and long that the idea works until they convince people it works - even if it doesn't.

Remember, this is the same bunch that once said options couldn't be valued - at all. They said that expensing options was double-counting when in fact it was no-counting. They fooled some of the people all of the time. And they'll do it again.

A lot more than most of us, I think it's fair to say. (And I'd be happy to admit it, too.)

Remember the Cisco system for divining dubious values on employee stock options? The one they've put on the SEC's plate for vetting? Then read this article from Dow Jones Newswires by way of CNNMoney: "Stock-Option Guru Scholes Doubtful On Cisco Value Plan."

Mr. Scholes' comments are straight out of Econ 101, (see: supply & demand). "In order to bring "a very idiosyncratic contract to the market," he said, it would have to be sold at a discount "in order to encourage the market to take it."

While Cisco is billing the alternative market price as an attempt to find an "accurate" valuation for stock-option expensing, Scholes said the market auction proposal is one that by its nature will not draw a true price. For one thing, a small market placement and little liquidity means the issue would likely sell at a discount...the outsider with less information [than Cisco] would pay less for such an instrument than the cost to Cisco."
[Emphasis added.]

Sounds sensible. Mr. Scholes makes some sound points about the robustness of the market for these instruments; I would have liked to know what he thought about the "option on an option aspect" of the instruments as well, but the interview or the article didn't go there. We'll have to wait and see if the SEC reaches the same conclusions as he does.

Let me state the facts up front: I am a shareholder of Colgate-Palmolive and I have been for years. I own it, and it's in accounts that I manage for clients. I've held it for years because I have high regard for the company, and I still do. But there's a situation brewing there that bears watching.

In the ongoing AIG International investigation, former General Re CEO Ronald Ferguson has been questioned by the New York State Attorney General's office over questionable transactions with AIG International. At Colgate-Palmolive, Mr. Ferguson chairs the audit committee, and is a member of the finance committee.

Also in the AIG International investigation, Ms. Elizabeth Monrad is responding to regulators' questions about General Re transactions with AIG International. Ms. Monrad was the chief financial officer of General Re, and has since moved on to be the chief financial officer at TIAA-CREF. The pension fund reports "that she received a “Wells” notice from the enforcement staff of the Securities and Exchange Commission. " Ms. Monrad is currently on leave of absence from TIAA-CREF. At Colgate-Palmolive, Ms. Monrad chairs the finance committee, and is the deputy chair to Mr. Ferguson on the audit committee.

While not involved in the insurance transactions, Colgate nevertheless finds itself affected by them: Mr. Ferguson and Ms. Monrad are very key persons on the Board. I make no assumption of any wrongdoing by them - that's for the regulators to determine - but one can imagine that while they're under investigation, their priorities may be quite different than they were at the beginning of 2005. How long will the investigations last? How will their priorities be reassigned as the investigations continue?

Most importantly: where does Colgate-Palmolive fit into the priorities of Mr. Ferguson and Ms. Monrad? The audit and finance committees need the talents of its members even more urgently as Colgate embarks on its ambitious plans to rationalize capacity. The distractions posed by the investigations are a concern to me. They should be a concern to all other long-term Colgate-Palmolive shareholders as well.

One side-effect of the Sarbanes-Oxley Section 404 has been a heightening of precision in what companies consider to be a "material" error or misstatement. Not a bad thing at all: in the wild and wooly 90's, SEC officials stated concerns that financials were were deliberately presented with known errors that were dismissed as "immaterial" but helped firms in getting over the bar for earnings estimates. Multiply a penny per share by 100 million shares outstanding and a price-earnings multiple of 30, and you're talking about some serious market cap fluff.

The SEC is rumored to be developing a release for this summer (probably a Staff Accounting Bulletin) which will suggest when long-running errors that might have been immaterial in any one period should be cleaned up all at once. It will likely augment - and not replace - the six-year-old Staff Accounting Bulletin No. 99, "Materiality." That particular interpretation now looks like it's being applied with much more rigor. Case in point: Wyndham International.

The hotel operator filed an amended 10-K and a non-reliance 8-K yesterday. In the 8-K, the firm disclosed that "the Company identified an additional tax charge of $1.7 million related to 2004 and reconsidered other previously identified but deemed immaterial adjustments related primarily to accruals of unbilled legal and consulting fees aggregating $1.8 million related to 2004. The Company's Audit Committee and management consider the charges to be immaterial to the Company's financial position and the results of operations for the year ended December 31, 2004. However, even though the adjustments are only 0.14% of the first quarter 2005 total assets, 0.15% of total liabilities, 2.5% of shareholders' equity and 1.2% of the first quarter 2005 total revenues, the $3.5 million adjustments as a percentage of the first quarter 2005 loss from continuing operations of $48,000 are significant. As a result, on May 11, 2005 it was determined that the financial statements for the year ended December 31, 2004 should no longer be relied upon.

The restatement resulted in the Company adjusting its previously reported 2004 net loss of $509.5 million ($4.01 per share) to net loss of $512.9 million ($4.03 per share)."

(Funny how a loss can magnify the effect of what would otherwise be considered an immaterial adjustment.)

Revisions like this might be quite common this summer and fall if the SEC guidance is issued and is as stringent as is expected. Restatements might emerge more frequently regardless, just because firms with internal control issues from the past reporting season might amp up their precision threshhold as they remediate their problems.