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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.

At the beginning of the month, I mentioned the SEC Advisory Committee on Smaller Public Companies and their effort to gather inputs about the rigors of regulatory life for corporate small fry.

The Committee was also "very interested" in hearing from investors. Hopefully they hear from them - but I also hope that they aren't simply mouthpiecing the same tripe they've heard from managements. So, I spent much of Monday offering my views through their questionnaire. It's not yet visible on the SEC's website, but I posted the whole shebang on the main Analyst's Accounting Observer site. If you're interested, you can get directly to the response here.

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It's official: the State of Maryland has declared August 26 to September 5 to be "the Eleven Best Days of Summer." For once I agree with them: it's State Fair time in Timonium, about ten minutes from my home. About an hour and a half last night was the perfect antidote to being cooped up in an air-conditioned office clacking away at a keyboard for days on end: familiar faces, not seen often enough; fair food like a smoked turkey drumstick and a frozen chocolate-covered banana; exhibits of prized crops and wonderful things you take for granted, like honey. And the smell: the aroma of baking funnel cakes, mixed with the smoke from the barbecue pits. It's a perfume that hits you once a year and reminds you that winter, with its sterile but pure air, is lurking in the coming weeks. The animal pens are another antidote: stroking a hairy four-legged prize winner is a welcome difference from stroking a plastic keyboard. But the smell of the animal pens does bring you back to earth: it's really close to the smell emitted from the whole big company/small company brouhaha now being stirred up by the AICPA.

Plenty of attention will be focused on the KPMG settlement, complete with navel-gazing contemplation of what it means for the future of the firm. Hey, I'm guilty of it myself - see yesterday's post. And I'm sure I'll do it again, maybe even before I finish this post.

Still, there are other interesting news nuggets out there. One of them: yesterday, the SEC settled fraud charges with four principal officers of Waste Management for a cool $30.8 million. The quartet included Dean Buntrock, the founder of Waste Management and its chairman and CEO for much of the time the frauds occurred. Waste Management, if you'll recall was kind of the grand-daddy of the 1990's accounting frauds - and an ominous precursor of Arthur Andersen's fate. Andersen may have killed itself with Enron, but it didn't cover itself with glory in its audits of Waste Management, either. And most obviously, Andersen's managers didn't learn many lessons from the Waste Management audits.

"The Commission alleged that, beginning in 1992 and continuing into 1997, defendants engaged in a systematic scheme to falsify and misrepresent Waste Management's financial results with profits being overstated by $1.7 billion. The fraud resulted in a restatement in February 1998, which at the time was the largest restatement in history." [Emphasis added.]

Think about it: Andersen doesn't get tough on Waste Management monkeyshines over a five-year stretch. The result is the largest restatement in history - with profits overstated by nearly $2 billion. (In fact, if memory serves me correctly, there were multiple restatements.) And Andersen sleeps right through the wake-up call: Waste Management's gig was up two and a half years before Enron self-destructed. There was enough time for Andersen to see how many rats were in its basement, but nobody bothered to open the door.

Some of the misdeeds charged against the four principals (which, of course, were settled without admission or denial):

- Waste Management manipulated its depreciation expense by extending the useful lives and overstating the salvage value of its trucks and containers, thus reducing current depreciation charges.

- The firm didn't write off impaired assets; it improperly capitalized interest and other current expenses.

- The firm understated its income tax expenses, under-accrued reserves, gamed its acquisition accounting methods, and brought "cookie-jar" reserves into earnings.

The net effect of these maneuvers: increased current earnings while deferring costs. Tastes great, less filling - but what a hangover. Andersen got past its hangover, and partied on for a few more years. But that's all. Perhaps there's a reminder for KPMG's managers in the timing of the Waste Management settlement with KPMG's own: you just don't get in trouble for taking the high road. It would be refreshing if someone got the message.

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A fitting end to summer.

In June, the word spread that the Justice Department was considering an indictment of Number Four KPMG - making a sure-fire subtraction from the ranks of the Big Four, and a likely addition to the graveyard of failed auditors. At the end of the summer, we've got the conclusion. It's like the television season, only played in reverse.

All summer long, the guessing game was played. Would the Justice Department go nuclear? The SEC appeared concerned that it would; they devised contingency plans for handling the next auditing season should there be only three firms. Would there be a "deferred prosecution agreement" a la Time Warner and Bristol Myers Squibb? Before this summer, only lawyers were familiar with the term; over the summer, it became commonplace phrase.

And in the end, that's what KPMG got: another lease on life thanks to a deferred prosecution agreement. The firm's partners will get socked with a $456 million settlement over the next 16 months, averaging $300,000 per partner. It will face severe oversight and restrictions on its tax business. But it will survive.

Having had a near-death experience, will KPMG go in the complete opposite direction of its errant ways? It doesn't have much choice: it's going to be subject to enough ongoing monitoring that it might be difficult to deviate from the straight and narrow. Will it reinvent itself and maybe be a model of behavior for the other Big Four? Too soon to tell. But the firm is capable of adapting: read Lynnley Browning's excellent account of their evolution in becoming a tax shelter powerhouse in this Saturday's NY Times. Maybe the firm can put some of that desire and innovation into becoming the premier auditing firm, now that they've got something to prove.

Former Kmart CEO Charles Conaway may have dodged one bullet when he was cleared of civil wrongdoing by an arbitration panel. The panel found that Conaway "acted at all times in good faith and in what he believed to be the best interests of K-mart."

That's their version. The next bullet, from the SEC, is a much different version.

On Tuesday, the SEC charged Conaway with fraud, along with the former CFO, John McDonald. Their lack of forthrightness and candor in the Management's Discussion & Analysis 10-Q for the third quarter and nine months ended October 31, 2001, and also in an earnings conference call with analysts and investors, is what pulled them into the SEC's sights.

From the Commission's press release:

The Commission alleges that, in the MD&A section, Conaway and McDonald failed to disclose the reasons for a massive inventory overbuy in the summer of 2001 and the impact it had on the company's liquidity. For example, the MD&A disclosure attributed increases in inventory to "seasonal inventory fluctuations and actions taken to improve our overall in-stock position." The Commission alleges that this disclosure was materially misleading because, in reality, a significant portion of the inventory buildup was caused by a Kmart officer's reckless and unilateral purchase of $850 million of excess inventory. According to the complaint, the defendants dealt with Kmart's liquidity problems by slowing down payments owed vendors, thereby withholding $570 million from them by the end of the third quarter. According to the complaint, Conaway and McDonald lied about why vendors were not being paid on time and misrepresented the impact that Kmart's liquidity problems had on the company's relationship with its vendors, many of whom stopped shipping product to Kmart during the fall of 2001. Kmart filed for bankruptcy on Jan. 22, 2002.

The SEC's version doesn't square much with the panel's version. The actions of the executives are really a shame: in the end, the company went bankrupt anyway. Maybe it would have been over with quicker if they'd been honest about things in the first place - and the execs would have saved themselves face time in court and with the SEC.

Yesterday, PricewaterhouseCoopers released one of its quarterly "Management Barometer" surveys of over 147 CFOs and Managing Directors, of which 71 (48%), are associated with firms having a defined benefit pension plan. Purpose of the survey: what do you really think about your defined benefit pension plans?

A small sample, for sure. Yet the findings are pretty consistent with what you'd expect:

- The top concern of 73% of large employers with a defined benefit pension plan report that their number-one concern is expense and funding volatility.

- Most firms - 67% of them that made a plan change during the past three years, or expect to do so - consider freezing it or closing it to new hires as viable options for handling the volatility concerns.

- About half of the firms planning changes within the next 12 months will consider terminating their plan.

Reform of pension plan reporting is likely - and it will likely increase cost volatility. Continued worship of that bitch-goddess "smooth earnings" will lead cowardly managements to abandon an employee benefit that they once considered to be an attractive way to reward and retain valued employees.

(As long as they didn't have to clearly report what it cost...)

The drama at KPMG may be nearing an end: we might not have to worry about the Final Four going to a Thrilling Three after all. The Wall Street Journal reports that former SEC chairman Richard Breeden might be appointed as an "outside monitor" at the embattled accounting firm. It would be nothing new for Breeden: he had a similar watchdog post at MCI Worldcom and was chairman of Coopers & Lybrand's worldwide financial services practice for three years following his SEC tenure.

The article also mentions that the firm is likely to face $450 million in fines for its malfeasance in selling sketchy tax shelters. Don't expect audit fees, at least KPMG's, to wilt anytime soon.

Quite a while ago, I mentioned a pair of "higher education" schools that had a little trouble with how to account for revenue - Career Education Corporation and Investools.They've been joined by another for-profit school chain: yesterday, Corinthian Colleges filed a non-reliance 8-K covering its annual financials from 2001 to 2004, and the first three quarters of fiscal 2005.

Corinthian had a couple of problems in its revenue accounting. One, it didn't consistently account for the pro rata portion of revenue of students starting classes after the beginning of the month. Sometimes, it accounted for the revenue on a pro rata daily basis, which is a precise way of doing things; sometimes it included a whole month of revenue no matter when the student started in the month.

The inconsistency was due to the fact that the "legacy" Corinthian Colleges firm accounted for revenue on a monthly basis, while some of the firms it acquired accounted for revenue on a daily pro rata basis. Apparently, the firm didn't mesh the two conflicting systems together at acquisition. If you're looking for examples of where accounting controls took a back seat to growth by acquisition, include this one.

The second revenue issue had to do with "externships," one of the bugaboos at Career Education Corporation. Upon completing their "in-house" studies, students enter an externship afterwards. Corinthian recognized student revenue over the period ending with the in-house studies, instead of the longer period including the end of the externship. That has the effect of recognizing revenue earlier than when Corinthian's services have been completely delivered to the student.

The revised financials will incorporate a mid-month convention for revenue recognition, with a half month of revenue recognized in both the initial month and the final month of attendance - and tuition revenue will be recognized through the end of each student's externship period.

Cumulative effects: retained earnings at the end of fiscal 2004 will decrease by approximately $16.9 million. About 52% of the impact is related to the mid-month convention and the rest is related to extending revenue recognition through the externship period. Diluted net earnings per share will decrease by approximately $0.04, $0.04 and $0.06 for the fiscal years ended 2002, 2003 and 2004, respectively, and $0.04, $0.00 and $0.01, for the quarters ended September 30, 2004, December 31, 2004 and March 31, 2005, respectively.

The amounts involved aren't necessarily small on a relative basis: the company earned $.44, $.72 and $.87 in years 2002 through 2004. That's an overstatement of 9%, 6% and 7% in those respective years. Value Line shows an average annual P/E ratio of 25.6, 26.6 and 33.6 during those three years - so even small overstatements could have a significant effects on the company's market cap. At those multiples, the incremental earnings were worth about a buck of share price in 2002 and 2003, and two bucks in 2004.

Summer vacation is ... over. Sigh.

Traveled a lot, saw a lot, and read a little. One thing I read with great delight: a book by John Steele Gordon, entitled "The Business of America." If you're a business history fan, as I am, you'll enjoy it.

And one of my favorite parts was in the foreward, where he quoted Noel Coward: "Work is so much more fun than fun."

Couldn't have said it better myself. So - let's get back to the fun.

With this posting, The AAO Weblog is powering down to a comfortable archive-mode idle for a while.

I'll be off until sometime late in the month; exact date unknown. No new posts until then, but be assured (or warned) that the usual dosage of accounting-related blather will be dispensed as soon as I get back. In the meantime, feel free to explore the archives. And get out and get some summer sunshine, why don't you?