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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.

Interpublic Group has finally filed its 2004 10-K, complete with restated information for 2003 and 2002. The company has been going through the mill over at least the last year, and investors have been in the dark when it comes to current, relevant financial information. The annual report incorporates their assessment of internal controls; as you might expect when a company is over six months late in filing an annual report and restates prior years, controls are in pretty bad shape. As for the auditor's assessment: they disclaimed on the controls. The report lists a mere eighteen areas needing improvement, abstracted here: "1. The Company did not maintain an effective control environment. 2. The Company did not maintain effective controls over the accounting for purchase business combinations. 3. The Company did not maintain effective controls over the accuracy and presentation and disclosure of recording of revenue. 4. The Company did not maintain effective controls to ensure that certain financial statement transactions were appropriately initiated, authorized, processed, documented and accurately recorded. This was primarily evident in the following specific areas: client contracts, incentives and rebates; write-offs of aged accounts receivable, expenditures billable to clients and amounts billable to clients; fixed assets purchases, disposals, and leases; accounts payable and accrued liabilities; payments made for employee compensation; cash and cash equivalents, wire transfers, and foreign currency transactions; arrangements with derivative instruments; intercompany transactions; purchase of equity of investments in unconsolidated entities; and purchase, disposal or write-off of intangible assets. 5. The Company did not maintain effective controls over the complete and accurate recording of leases in accordance with GAAP. 6. The Company did not maintain effective controls over the accounting for income taxes in operations outside of the United States to ensure amounts are accurately accounted for in accordance with GAAP. 7. The Company did not maintain effective controls over reporting local income tax in the local statutory accounts or local income tax returns in operations outside of the United States. 8. The Company did not maintain effective controls relating to the completeness and accuracy of local payroll and compensation related liabilities in certain operations outside of the United States. 9. The Company did not maintain effective controls over the accuracy and completeness of the processing and monitoring of intercompany transactions, including appropriate authorization for intercompany charges. 10. The Company did not maintain effective controls over the reconciliation of certain financial statement accounts. 11. The Company did not maintain effective control over the monitoring of financial statement accounts to value and record them in a timely, accurate and complete manner. Specifically, controls were not designed and in place to: compare revenue recorded to amounts billed to clients; identify contracts with potential client rebates; analyze collectibility of aged accounts receivable or expenditures billable to clients; compare billable job costs to client cost estimates; review fixed asset records for under utilized, missing or fully depreciated assets; ensure that the underlying records support liabilities related to employee compensation, including an inventory of foreign employee pension plans, census data to calculate pension liabilities and changes made to benefit plans which impact the Company's compliance with certain employment and tax regulations; review intercompany balances for appropriate classification; review foreign currency translation adjustments; analyze accrued expenses and underlying equity of investments in unconsolidated entities; test intangible assets for impairments; or review equity accounts for appropriate roll-forward. 12. The Company did not maintain effective controls over the period end financial reporting process, particularly with regard to proper approval of journal entries and adequate review of financial statements. 13. The Company did not maintain effective controls over the safeguarding of assets. 14. The Company did not maintain effective controls over independent service providers. 15. The Company did not maintain effective controls over access to the Company's financial applications and data. 16. The Company did not maintain effective controls over spreadsheets used in the Company's financial reporting process. 17. The Company did not maintain effective controls over the communication of policies and procedures. 18. The Company did not maintain effective controls over monitoring the performance of proper application of the Company's internal controls over financial reporting and related policies and procedures." For a company the size of Interpublic Group - $12 billion in assets, nearly $5 billion in market cap (as of last night) - that is quite possibly the record number of weaknesses in this first year of internal control reporting. As the commercials say: "But wait - there's more." PricewaterhouseCoopers hasn't finished their audit of internal controls over financial reporting as of December 31, 2004; they disclaimed their opinion. And Interpublic admits that they have "extensive work remaining to remedy the material weaknesses described above." Maybe there are more striking examples of a control environment gone amuck in a big-cap firm, but I don't know where they are. Drop me an e-mail if you do; please don't say Fannie Mae or Freddie Mac, because they are still works-in-progress. This is going to be a very interesting stock market reaction to watch. A year ago, market participants were agog at the prospect that firms might report negative opinions on internal controls; now they brush them off, and often dismiss them as the province of small companies and with little concern over any implications of poor management (as long as they make the numbers, right?) This is no minor company; its internal control problems are not confined to one area; and they're still being evaluated and remedied. As I write this - before the opening of the stock market - the company is conducting a two-hour conference call to discuss the restated financials. It should be an interesting opening for the stock....

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Yesterday I mentioned the 29% growth in revenues for Grant Thornton: not shabby for any company in any industry to grow revenues that quickly, I thought. And $$748 million of revenues can pay a lot of salaries.

Just to remind you why the Big Four is the BIG Four, and the next five to eight are almost insignificant (see William McDonough's remarks in the same post), Ernst & Young released their year end revenue figures today: $16.9 billion for the year ending June 30, 2005 - a 16% increase over last year.

Sixteen percent growth is not exactly sluggish - and definitely not sluggish when you're talking about a revenue base numbering in the billions of dollars. Note that Ernst & Young's revenues were 23 times Grant Thornton's. Is it clear why the Big Four isn't likely to be the Big Five any time soon?

Yesterday I mentioned the 29% growth in revenues for Grant Thornton: not shabby for any company in any industry to grow revenues that quickly, I thought. And $$748 million of revenues can pay a lot of salaries.

Just to remind you why the Big Four is the BIG Four, and the next five to eight are almost insignificant (see William McDonough's remarks in the same post), Ernst & Young released their year end revenue figures today: $16.9 billion for the year ending June 30, 2005 - a 16% increase over last year.

Sixteen percent growth is not exactly sluggish - and definitely not sluggish when you're talking about a revenue base numbering in the billions of dollars. Note that Ernst & Young's revenues were 23 times Grant Thornton's. Is it clear why the Big Four isn't likely to be the Big Five any time soon?

One of the perennial problems for the Financial Accounting Standards Board: its very existence is supposed to benefit investors more than any other constituency, yet they ignore it. Whenever FASB floats a new rule that might significantly increase reporting clarity, they're deluged with protests from financial statement preparers - while the investing community remains mum.

How come? Any number of possible reasons: many of them don't consider financial reporting important. (They get what they deserve.) They're too busy ("I have thirty stocks to follow and they turn over all the time...") They're free riders ("Someone else will study this - if any good comes out of their effort, I didn't have to spend my time on it.") Or they fear corporate good graces being turned off if they take a public stance on a controversial reporting issue. (See Altera and other analyst retaliation examples.)

The FASB is trying to more actively involve investors by building a ready task force of significant institutional investors. Diya Gullipalli describes FASB's plans in this morning's Wall Street Journal. Take a look at the roster:

"The task force includes asset-management firms like Fidelity Investments, Marsh & McLennan Cos.' Putnam Investments, T. Rowe Price Group Inc., Wellington Management Co., Mellon Financial Corp. and Capital Group Cos. The firms will make their staff available to the board to provide feedback on pending rules."

An excellent idea on FASB's part. Maybe they learned something about the political process when they were going through the stock option battles of the last few years. It'll be a challenge to keep the task force running effectively, but it's worth a try to get investors more involved.

And you can get it if you try, apparently.

WebCPA reports that Grant Thornton's revenues for the year ended July 31 totaled $728 million.

The article doesn't mention the sources of the increased revenues, but the logical guess is that increased time spent on Section 404 reporting drove the gains.

* * * * * * * * * * * * * * * * * *

While on the subject of auditing firms, here's an interesting quote in today's Financial Times from outgoing Public Company Accounting Oversight Board chairman William McDonough:

"None of us has a clue what to do if one of the big four failed," Mr McDonough told a conference in New York. He said if one of the big four were to collapse, the best accountants could choose to quit the profession...He said even if the firms ranked five to eight in the US were rolled into one, the result would not be a business to match the capabilities of the big four.

Well, maybe the only thing to hope for is that "firms ranked five to eight" continue to grow at about a 30% clip for a while...

As corporate America begins its sullen march towards full reporting of stock compensation beginning in January 2006, there are bound to be "Oh-my-God" revisions to prior understandings about the workings of Statement 123 Classic, and new nuances of Statement 123 (Revised). It looks like Manor Care has had one of those "Oh-my-God" moments. The firm filed a non-reliance 8-K for its first-half 2005 filings, to be restated. Here's the reason why.

Manor Care reviewed its stock compensation accounting policies in the first quarter of 2005 in contemplation of implementing Statement 123(R). In its review, the firm uncovered one of those 123(R) nuances: it added a lot more description on how to figure out the service period over which stock compensation (whether it be minted in options or restricted stock) should be amortized. Whereas previous practice was more or less tied to explicit service periods, 123(R) required amortization over a shorter implicit period, if one is present in a compensation agreement. That is the apparent nub of Manor Care's situation: they had run amortization of restricted stock awards out to the expected actual retirement date of employees - which was longer than when they were eligible to retire. So under 123(R), amortization of the restricted stock awards is to be reported over the shorter, eligible period. Manor Care dutifully recorded a pretax charge of $10.3 million ($6.6 million after tax, or 8 cents per share) to catch up the compensation expense for years 2000 through 2004; no restatement of prior years, due to immateriality.

In addition, Manor Care recorded $8.2 million ($5.2 million after tax, or 6 cents per share) of restricted stock compensation for "retirement eligible" employees in the first quarter of 2005 - and here's where the confusion begins. After the 1Q earnings release, the firm's auditors, Ernst & Young, informed Manor Care's management that the SEC staff would continue to accept the old practice of amortization all the way up to the actual retirement date, "due to widespread practice," according to the filing.

(Funny: earlier this year, the SEC didn't accept the widespread practice of incorrect lease accounting. Maybe that's because those issues were twenty years old...)

Compounding the delay of all of Statement 123(R)'s requirements, the SEC staff would require "a continuation of the old practice for awards granted prior to the adoption of FAS 123(R),"according to the filing. In other words, only grants after 123(R) becomes effective will be getting the "implicit" period treatment.

Another wrinkle: deferred tax assets of $8.6 million ($6.9 million of which was recorded in the first quarter of 2005), shouldn't have been recorded because they won't be realized because of limits on the deductions allowed for executive compensation. It's a material amount for 2005, though not for prior years.

What's the remedy? Manor Care is pulling its year-to-date quarterly filings, and reverting back to its old accounting for the amortization of restricted stock compensation (over the longer service period) and also properly stating its deferred tax assets. The impact is mostly in the first quarter: general and administrative expenses are reduced, and pretax income is increased by $17.7 million. The deferred tax asset revision increases income taxes by $8.6 million. Combined effect: net income increases by $9.1 million, and diluted EPS increases by 10 cents. The second-quarter effect is negligible, with no change in diluted EPS.

Apparently the SEC is seeing a lot of implementation faux pas and is making allowances; this one is not something they covered in Staff Accounting Bulletin No. 107, which was their Statement 123(R) "how-to"handbook. It might be helpful for them to make some form of broader statement about this sometime before they make comments on reporting issues in the AICPA's widely-scrutinized National Conference on Currrent SEC and PCAOB Developmentsforum. (Maybe a letter like the famous February 7 leasing letter to the AICPA?) As we've seen with Manor Care, companies are working on the implementation now. December will be way too late. Is it effective for investors and analysts to see companies "toggling" their 2005 reporting back and forth between old reporting and new reporting? I don't think so.

At the same time, investors and analysts will have to expect bumps on the road to 123(R) implementation and learn to deal with them. While it's not totally different from its predecessor, that Statement was probably applied without much rigor because preparers considered it "only" a footnote disclosure. Their precision limits might be a lot tighter when 123(R) information is reported in the basic financial statements.

Delta Air Lines' bankruptcy on September 14 has flushed out a couple of impairment charges by a couple of other players - ones that had invested in leasing aircraft to the Atlanta icon.

Your first guess might have been a bank or leasing institution - and that would have been a bad guess. The day after the bankruptcy filing, Electronic Data Systems filed a "material impairments" 8-K disclosing its $26 million writedown of leases to Delta.

Another one emerged today, this one out of the House of Mouse: Disney. Not the first lending institution that jumps to mind, their writeoff was $68 million. They also noted the possibility of an acceleration of $100 million of tax payments should Delta successfully shuck the leases during its Chapter 11 rehab session.

Nothing skanky about the two transactions at all; in fact, Delta was noted as being a lessee in the 10-K filings of both companies. It's just a reminder of how broadly intertwined American business can be at times. It can't help but make you wonder a little bit about the wisdom of diversification: the portfolio manager who diligently avoids airlines because they're in such difficult straits might nonetheless still be exposed to them by his or her show biz investments - a business that's supposed to be stable and growing.

It also makes you wonder about the degree of interdependence among firms when it comes to derivative transactions. Guess we'll find out the next time one dissolves.

Friday's announcement that William J. McDonough, Chairman of the Public Company Accounting Oversight Board, will be stepping down on November 30 (sooner, if his replacement is found before then), sent ripples of speculation through the accounting community.

Why now? Is there something afoot? Another shoe to drop?

I don't think so. My guess is that the PCAOB is starting to mature, and there isn't the same kind of urgency to keep McDonough satisfied. He's a pretty dynamic fellow, not one driven by the calendar; he's a "young" 71-year-old. As he put it in the PCAOB announcement: “I have a wide range of interests in corporate governance, finance and international affairs and will explore one or a variety of activities in those fields; I enjoy perfect health and have not the slightest interest in retiring, now or ever.”

The rumor mill has buzzed about McDonough's pending departure for months; one story had it that he was interested in running Fannie Mae. Maybe something like that is on his horizon, but I'm more interested in who heads up the PCAOB next. That might tell us more about its status.


Incidentally, in an interview with the Financial Times, McDonough warned the auditing profession that they shouldn't expect lawmakers to support any legislation that caps auditor liability. "I do not think the American people would support legislative remediation of the auditor's risk until the audit profession has really won back the confidence of the public," said Mr McDonough...

Last post was on analyst communications... continuing on that theme, take a look at this resignation letter a from Michael P. Berry, who's now a former director of Corinthian Colleges. (It's an exhibit to a "departure of officer" 8-K filed by the company.) You may recall that COCO had a restatement issue due to revenue recognition last month.

It's a fascinating look at the views of an insider - okay, former insider - and provides an incredible contrast to the usual slickness of analyst conference calls and dreary pablum served up in most "Management's Discussion & Analysis" sections of SEC filings.

For example, do you recall seeing anything like this in any MD&A you've read?

"We are out of control on both the revenue and cost management side of our business, and it is attributable to several factors. Our past success was due to our acquisitive business model. Our present failure is due to the fact that we have not shown the ability to manage those acquired, multiple assets (schools) in our portfolio other than WyoTech. That is due to many factors, not the least of which is a very weak field organization."

Or this:
"I am further bothered by the fact that despite poor operating results, our compensation policy is approaching a level where total compensation is not consistent with performance. Specifically the annual stock grants given out over the years to management at all levels as a percentage of outstanding shares are unacceptably high. Companies our size should not be giving grants of 50k – 75k shares to so many EVPs and SVPs year after year. This is one of the areas our compensation policy is out of control."

Or this:
"As for the board itself, we were each instructed upon selection that consensus is a how the board operates. That to me in the end requires papering over real differences. It is ironic that during the last three plus years on the board, there has been not one dissenting vote on the board other than one time I vote no, and another couple of times I abstained. No one else has ever voted either no nor abstained. That is the result of not truly reaching consensus, but needing to appear to be unified, and papering over differences because there is no confronting the brutal facts.

... That the board is driven by such a consensus model does not serve the needs of our shareholders. Given that reality, I cannot continue in good faith to be on a board that in my opinion operates in a manner inconsistent with good practice. Likewise, I wound not have agreed to take my issues outside the board room as you suggested. They belong properly put in a respectful manner in the board room. If you have objections to my manner and approach, I assure you I could have modulated that, but it is hard when probing questions are met with the same recitation heard so many times before. The probing is necessary to get to the facts, since deep and thoughtful insights and analyses are not forthcoming. "

Well, of course you wouldn't see any of these dispatches in any MD&A. And Berry does give analysts credit for downgrading the firm and not accepting all of the party lines they've been given about the company's performance. But it should also make you think about what goes on behind the filings and the PR-driven, homogenized conference calls. The letter is recommended reading just for shock value alone, and not specifically about Corinthian Colleges. It's a reminder of how dangerously sterile fundamental analysis might become: analysts and investors want a one-minute, five-bullet point summary of what a company is "all about," and companies keep them contented by PowerPointing their investor audiences into brainwashed submission. A lot gets lost outside of those PowerPoint presentations, apparently.

Plenty of observers - self included - wondered if new SEC Chairman Christopher Cox would favor business over investors.

So far, he hasn't opened the Pandora's box of option expensing accounting; he's taken no action to overturn the FASB rule. His remarks on the Cisco derivatives proposal were unsettling - but you could also read them as ambivalent.

Today's Wall Street Journal reports an interesting new focus for the SEC: the subject of corporate retaliation against analysts who publish unfavorable opinions or reports. In a letter to Rep. Ron Wyden of Oregon, Chairman Cox indicated that "this is indeed a concern and we will tackle it." Apparently, the SEC has already interviewed nine brokerage firms; six of them listed retaliatory practices as a problem. New regulations might be on the way.

Analyst folklore is rife with stories of analysts being frozen out of corporate communications; it's a good idea for the SEC to make sure that all opinions on a company can be heard, without bias towards only corporate sycophants. The puzzling thing to me is this: if the SEC's Regulation FD is working as intended - to provide equal access to corporate communications - then why is this even an issue? If negative analysts are being frozen out of things like "special invitation events", doesn't that imply that something isn't working right in Reg FD? Perhaps enforcement of that rule is needed before issuing new ones.