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The AAO Weblog covers accounting issues and current events as they relate the practice of investment analysis. All posts prior to September, 2007 are in the public domain, but after September 4, 2007, only subscribers to The Analyst's Accounting Observer will see all posts going forward. Only selected, occasional posts will be released to the public domain from September 4 forward.

AAO Weblog (Public)
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.
Mail Call: Biz Com Proposal
By Jack Ciesielski on 10/31/2005 7:58 AM
This note, from a friend in Boston, on my comment letter on FASB's proposal on cleaning up business combination accounting to make it report transaction fair values more effectively:

"Jack, I agree with your comments on bizcom with the exception of pre-deal costs. You say that these costs do not generate returns. I agree, but management better generate returns on them - I gave them the capital! If you bought a house for $100 and incurred transaction costs of $3 and then sold the house later on for $103, did you make $3 or $0 of profit? The other analogy often offered is that when I do an envirormental study for a steel mill (the cost of entry), that is capitalized - why is the buy vs build decision different?"


I think there are more benefits for investors in the proposed accounting than under current practice. A few reasons:

One, as I said, the payments to the bankers, accountants, lawyers, etc. only allow access to the assets. They do not generate the returns. If management is going to spend my money to employ these guys, I want to know how much and I want to know now so I can criticize while it's closer to the time when they're spending my money - when I have more of a chance to affect their decisions than if I have to wait a couple years for a goodwill writedown while they get paid plenty for managing my company. (And after a goodwill writedown, I still wouldn't know how much of any goodwill writedown really was related to transaction costs.)

Two, as I said, I sincerely believe these payments are of little future value, they are transaction costs. Putting sunshine on transaction costs has a way of making managers manage such costs. Putting it in current earnings makes them worry more about managing resources, I think, especially in context of making the numbers. Giving them a place to bury costs on the balance sheet encourages sloth.

Three, the FASB is serious about a fair value presentation of the balance sheet wherever possible. Excluding the transaction costs puts ONLY the fair value of the assets/liabilities on the balance sheet. Adding the transaction costs dilutes the meaning of the assets immediately.

In an income tax reporting model, I'd sure want to report the transaction costs as part of the basis in figuring a gain - unless I could deduct them earlier, before I sold the house. I can't do that for taxes, but I think it makes sense in GAAP. I admitted in my letter that this is at odds with other treatments - inventory , and securities being two examples - but I think that either of those methods do not accurately reflect fair values. Analogies are often helpful, but I don't think this is analogizing to a good model. Fair value is not something we're going to have to pick and choose - I think we have to be consistent in applying it. I'd hope the FASB looks at other "capped" costs down the road.
No Theoretical Accounting, Please, We're The EU
By Jack Ciesielski on 10/31/2005 7:40 AM
Last week, I mentioned that I'd penned my response to the FASB's proposal for a second phase in cleaning up business combination accounting. The proposed standard is likely to be somewhat controversial: not because it's a single mammoth change in practice, but because it cleans up many long-standing sloppy acquisition practices - and I mean sloppy in terms of solid accounting theory.

You don't expect everyone to like change - most of all, you don't expect the companies preparing financial statements to appreciate changes. You do expect that organizations formed of accountants to be a bit more supportive of advancements in their craft - but it's not looking that way in the European Union.

Accountancy Age, a British trade paper about - what else? - accounting, reports that the Institute of Chartered Accountants in England and Wales (the ICAEW) has slammed the FASB proposal. (The ICAEW is to chartered accountants in Great Britain what the American Institute of Certified Public Accountants is to CPAs here in the United States.) According to Accountancy Age:

"Last week internal market commissioner Charlie McCreevy warned that IASB that 'convergence is not an invitation to standard setters to try and advance the theoretical frontiers of accounting'.

'I will not take on board any revolutionary new standards,' added McCreevy. 'This should be a practical exercise, firmly anchored in business reality, to be undertaken in the interests of users and investors.'"

I hope Mr. McCreevy understands that business reality is what needs to be reported better to users of financial statements and investors. If a standard that is on the "theoretical frontiers of accounting" reports business reality better than "practical exercises," it should be welcomed rather than shunned.
A Day In The City
By Jack Ciesielski on 10/28/2005 5:48 AM
Spent yesterday in New York; I had the chance to speak at the New York Society of Security Analysts' 12th Annual Financial Reporting Conference.

A good show for this kind of stuff, a really impressive cast of speakers, (pro forma-ing out myself there) and a surprisingly good crowd, given that it's earnings season. Always look for the backstory: it was less surprising when you realized that a lot of the audience was from the press. Still, it was good to meet up with some folks I've talked to for years and never met in person. (If you're reading this, you know who you are.)

A cold day in New York in the fall? Accounting? You call this work?

So, today's posting will be thin gruel indeed. There are two (long) Observer pieces that are begging for me to start, and I'm running in minimum-sleep mode. I'll be posting the talk I gave as part of a duo with Howard Schilit. Howard's done more than anybody I know to raise analyst awareness about accounting issues; our views on the question "has financial reporting improved?" weren't exactly symmetrical, but not exactly opposite either. Anyway, I'll put the script up next week on the Accounting Observer website. (Can't get it to the webmaster right now because I don't have the file with me.)

In the meantime, here's a link to my comments on FASB's business combinations exposure draft. Like I said, thin gruel. See you next week.
The Auto Industry SEC Flu
By Jack Ciesielski on 10/27/2005 3:25 AM
Same bug, different strain. They all relate to accounting, they relate to the SEC. It's the topics and the players that differ.

Almost a year ago, the SEC began investigations into pension and other postemployment benefit plan accounting at General Motors, Ford, Delphi, Boeing, Delphi, and Navistar. It wasn't any announcement by the SEC that clued in the public that such an investigation was going on: it was the disclosures by the players themselves in their public filings. There hasn't been a peep out of the SEC on the matter.

Another peep emerged from the disclosures of another filer: DaimlerChrysler. Mary Williams Walsh reported on Wednesday in the New York Times:

"...DaimlerChrysler disclosed that the Securities and Exchange Commission had served it with a subpoena in September seeking information in connection with a continuing investigation of General Motors' pension accounting. General Motors is one of six large companies whose pension accounting has been under review by the S.E.C. since October 2004. The others are Ford Motor, Delphi, Boeing, Navistar International and Northwest Airlines.

DaimlerChrysler said in a regulatory filing that the S.E.C. was seeking information related to methodology used in calculating pension and other retirement benefits for its North American employees. The S.E.C. said it also wanted to see "communications with G.M., Ford, and/or Delphi regarding such rate or methodology," according to the filing."

You can see the actual disclosures in the DaimlerChrysler 6-K, linked here.

It's still a puzzle. What did the SEC see in the investigations of the others that made a subpoena of DaimlerChrysler? Were these companies essentially passing around their homework to each other? And if so - was the homework correct? We'll just have to ponder it until either more clues seep out, or someone involved can actually talk about it.
The Puerto Rican SEC Flu
By Jack Ciesielski on 10/26/2005 7:53 PM
One of my favorite parts of the day's end: getting Fortune magazine's Street Life in the e-mail. It's a daily wrap-up of market events, authored by a rotating cast of some of Fortune's most entertaining writers. And it lets me know what I missed during the day - like today. Says Andy Serwer in today's column:

"SAN JUAN SINKHOLE: Have you been following this Puerto Rican bank scandal? Me neither. Until now. Turns out the three biggest financial institutions there are under fire for bad accounting. Doral Financial, the island's biggest mortgage lender, just revealed that the SEC has begun a formal investigation. Stock is down to $8.80; it was close to $50 earlier this year. First BanCorp and R&G have also announced problems. Watch this space for takeovers! Hello? Chris Flowers speaking...."

Nope, not exactly following it: but back in April it was noted in this space that Doral Financial was making some pretty serious adjustments to its interest-only residuals resulting from securitizations of loans. And in July, it was noted that R&G Financial (absolutely, positively no relation to R.G. Associates, which is - me) was also having trouble making its accounting work when it comes to securitizations. As for First BanCorp, that one went by me. It is rather curious: three big players in a small area all coming down with the accounting flu.

Let's follow it now, at least for a little bit. First, a look at the First Bancorp announcement of the SEC investigation released last Friday:

One issue under review by the Audit Committee is whether the mortgage transactions at issue were properly classified for accounting purposes as purchases of the mortgage loans by First Bank or whether they should have been treated as loans by First Bank to the other financial institutions, secured by the mortgages. Although the Company's accounting analysis is not complete, First Bank has concluded that most of its transactions with one financial institution, R&G Mortgage Corp, did not qualify as true sales as a legal matter. Accordingly, these transactions may need to be accounted for as a secured loan to that financial institution. As a result, First BanCorp may be required to restate its previously issued financial statements for the period from 2000 through the first quarter of 2005.

Any reclassification of the transactions as secured loans rather than as purchases of mortgages would affect the notes to the Company's financial statements as well as the Company's presentation of its cash flow from investing activities. The Company is reviewing the adequacy of its allowance for loan losses relating to the potential reclassified secured loans as well as the regulatory capital implications of the reclassifications. Any need to change the allowance for loan losses would impact previously reported net income and loans net of allowance for loan losses.

Interesting: looks like R&G Financial and First Bancorp may have gotten the flu from each other. R&G Financial, in yesterday's disclosure about the SEC investigation, was much less forthcoming - and made no mention of First Bancorp or any other institutions. As for Doral, its release today was for the purpose of notifying investors that "it no longer expects to file by November 10, its amended annual report on Form 10-K for the year ended December 31, 2004. The delay is principally attributable to new information regarding the Company's mortgage loan sales to local financial institutions."

Note the plural: institutions. It'll be interesting to see if there other players yet to be named involved in this - and especially interesting if any others are non-publicly traded players.
The Latest In Pro Forma Reporting
By Jack Ciesielski on 10/26/2005 7:51 AM
When it became clear that reporting stock option compensation was inevitable, you knew this was going to happen: compensation charges tied to stock options would simply become a backed-out item in the neatly-spun pro forma earnings. What you would hope though, was that such inane "add-backs" of compensation expense wouldn't be expanded to include restricted stock charges. Managers know a good thing when they see it: the early indications are that they're going to add back all stock-based compensation charges.

EBITDA reporting, long a staple of pro forma reporting, is being expanded to exclude stock-based compensation by some firms. One example is microelectronics supplier Entegris, noting in their earnings release that EBITDA excludes stock-based compensation containing primarily restricted stock charges. One wonders: will the term EBITDASC (Earnings Before Interest, Taxes, Depreciation, Amortization, and Stock-based Comp) become part of the financial vernacular? That's doubtful: aside from sounding awful, it just draws attention to the fact that the figures exclude something to which management would rather just not draw attention. Namely, their pay.

Last week, the Wall Street Journal's Justin Lahart reported that Linear Technology was excluding all stock-based compensation from their pro forma earnings - including restricted stock charges. Their earnings release is probably a model of what to expect from companies: they don't overtly state they're pulling out restricted stock from GAAP earnings to get to pro forma earnings. Instead, they note that stock-based compensation under Statement 123(R) includes all forms of stock-based compensation including restricted stock, and then proceed to excise total stock-based compensation charges from earnings.

There are plenty of companies excluding stock-based compensation charges from their earnings in the current reporting season, which is the first one that will include earnings with Statement 123(R) compensation charges. (That's for companies with June 30 year ends.) Beware the generic "Statement 123(R) stock-based compensation" add-back because companies aren't being extremely descriptive about what's in it. You might assume that it's just options expense, but it might contain a healthy dollop of restricted stock comp, too - and for years, that never really bothered anybody. It's hard to recall instances of constantly-reported restricted stock add-backs. (If you can think of any examples, please drop me a line.)

So what? It's easy to dismiss such charges as a simple non-cash charge, but it's getting to the point where we're almost talking about earnings before costs. During the stock option accounting wars, restricted stock accounting was never contentious, even though it hit earnings. Now that both kinds of stock compensation currency are being recorded, they're all getting thrown out of earnings under the rubric of being "non-cash" - as if they were non-compensation, too.

They're not non-compensation - they're a factor of production in an economy driven by the brains and services of employees. You want cash flow, go to the cash flow statement. You want valuation on a cash flow basis, go to the cash flow statement for a start, and project cash flows yourself and discount them to a present value. You want to know what happened in a company, in total