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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.

Check out Chairman Chris Cox's speech given yesterday at a Council of Institutional Investors confab in Washington.

Cox draws the comparison between the pay for athletes and entertainers and the pay for executives, and articulates very well the major difference between the way the two compensation sets are derived. The pay level for athletes and entertainers is based based on negotiation and their own popularity. The pay level for executives, however, can be influenced by them: they negotiate with their own board of directors, who are very likely to be executives themselves. They aren't negotiating with the shareholders who actually own the company, but depend on a board to represent their interests. And a good deal of intensity gets lost in that intermediation.

We'll see if the SEC's plans for compensation disclosure improve that bargaining process for shareholders - or just provides more fodder for the compensation consultants.

It's here. The FASB has released its proposal for (finally) making pensions visible in corporate balance sheets. (And in non-profit organizations' balance sheets too.)

You have to give them credit for one thing: when they announced the project last fall, they said they'd get the exposure draft out for this phase in the first quarter of 2006 - and they did, on this very last day of the quarter. In FASB-time, for a project of this size, that's like running four-minute mile.

And if they get this project finished and effective for year end 2006, that would be a virtual FASB windsprint. There's no logical reason it can't happen. The standard will make profound changes on balance sheet geography, moving some unrecognized deferred items out of the footnotes and into different locales on the balance sheet. It won't change the size of benefit plans' expense; it'll just make information already produced by firms visible on the balance sheet.

And it will probably be painful for most firms with benefit plans, of both pension and health care flavors - which will probably raise corporate hackles. So, the only reason that the standard doesn't get issued and become effective at year end is if there's a corporate rope-a-dope strategy: go to Congress, allege market meltdown due to standards overkill, ask for time to study the problem, etc. Keep tuned.

Anyone notice this little story in Business Week Online? (subscription required) An excerpt:

"A record 881 small companies filed with the Securities & Exchange Commission in 2005 to register new stock issues and raise $16.3 billion in new capital, according to a study by researchers SME Capital Markets. That's up from 435 in 2003."

The story goes on to note that while there was a deferral of SarbOx provisions until 2007, CFOs interviewed for the story said they'd have tapped the public markets anyway, "because they see no choice for raising capital."

Makes the whole idea of relaxing Section 404 seem, well, a little fallacious, doesn't it? And the letter that's referenced here raises an interesting point: that the SEC does not have the jurisdiction to make wholesale exemptions to Section 404.

It's a letter authored by a group of law professors, and submitted as a response to the SEC's request for comments on the final report of the Advisory Committee for Smaller Public Companies. (Strangely, I couldn't find it as a submission on its own; I found it as an attachment to the AFL-CIO's letter.) An important excerpt:

"The Congress, by not imbedding section 404 of Sarbanes-Oxley in the Exchange Act as it did with so many of its other Sarbanes-Oxley provisions, thereby chose to remove section 404 from the SEC's authority to exempt reporting companies from the requirements of section 404. The exclusion of section 404 from the Exchange Act is particularly revealing in view that Exchange Act Section 13(b)(2)(B) mandates that reporting companies "devise and maintain a system of internal accounting controls. . ." If Congress had desired section 404's requirements to be subject to Exchange Act qualification or exemptions that the SEC can adopt pursuant to section 36(a) of the Exchange Act, the natural step for Congress to have taken when enacting section 404 was to cast it as an amendment to Section 13(b)(2). Congress did not do this.

The conclusion that Congress intended all reporting issuers to be subject to section 404, and therefore beyond the power of the SEC to adopt exemptions under section 36(a) of the Exchange Act, is further supported by the language of section 404 which requires that the SEC "prescribe rules requiring annual report" of a reporting company include assessment by management of internal controls as well as the independent auditor's attestation of management's assessment."

Interesting stuff. The profs further suggest that the SEC can adapt their interpretation of Section 404 as they see fit; they simply can't legally touch its foundation because it's not in their charge.

As mentioned in a previous post, the SEC has been trolling for volunteers to file reports in the XBRL format that's touted as the next big thing in manipulable financial reporting documents by Chairman Cox. And as last reported here, the fish weren't exactly jumping into the boat.

Finally, the SEC has landed a few. Seventeen companies have stepped forward to be guinea pigs: 3M Company, Altria Group, Brazilian Petroleum Corporation, Bristol-Myers Squibb, Dow Chemical, Gol Intelligent Airlines (possible oxymoron there), Infosys Technologies, Microsoft, Mobile Reach International, Net Servicos De Comunicacao SA, Old Mutual Capital, Pfizer, R.R. Donnelley & Sons, South Financial Group, United Technologies, Xerox and XM Satellite Radio Holdings.

Gee, if only there was cheap, available end-user software out there for analysts and investors to use in evaluating the financials of the guinea pigs. There's nothing available from the SEC to assist users in making sure their noble experiment is providing useful information to investors.

Anyone out there know of any beta test software for working with XBRL files? Drop me a line if you do.

A couple of days ago, I mentioned a couple of small cap companies (Calgon Carbon & CSK Auto Group) in disparate industries that were united by a common thread: weak internal controls over some very basic accounting functions. Both companies were small enough to be "worthy" of the relaxed internal control reporting being considered by the SEC.

Here's more thread: Mattson Technology's non-reliance 8-K filed yesterday. In it, the company discloses that the "reported results for the first, second and third quarters of 2005 contained errors related to its recognition of revenue, assessment of inventory valuation, recording of depreciation and amortization expense for certain assets, and estimation of statutory liability for severance payments earned by certain foreign employees."With a $600 million market cap, Mattson Technology would neatly slip into the "smaller company" category of registrant being targeted for coddling by the SEC.

As with the other two companies (and other firms noted in this space from time to time, like Fountain Powerboat and Foamex), the issues that tripped up the firm are not exotic interpretations of derivatives accounting literature; they don't relate to weird financial instrument issues, or anything else extremely complicated, accounting-wise. The episodes are simply a lack of basic blocking and tackling - and they're real-world demonstrations of the folly of granting relief to smaller companies from applying full-strength Section 404 reviews.

Want more than just my anecdotal evidence? Check out the excellent report on restatements by Glass Lewis & Company. (Request the full report here.) Restatements are not exactly a service to shareholders; they're not a badge of honor for the restating companies. And very often, they're a symptom of weaknesses in internal controls. GLC found that of 1,195 restatements in 2005, 59% of them occurred in the very same "smaller company" categories that the SEC is considering. That's concrete evidence of the folly of this idea.

I've yammered about the small company exemption all along; I still can't buy into it. I think the opposition to SOX is almost a "secret handshake" kind of thing among financial execs: if you don't oppose Sarbanes-Oxley at every opportunity, you're margarine, you're just not a "real" manager. (Maybe it's like liberalism in Hollywood; if you don't show it, you don't work.) Maybe such managers don't realize that their attitude is embedded with cynicism towards the shareholders, who actually own the companies and are the ones who benefit from the application of SOX 404 reviews. And you don't hear too many of them calling for preferential treatment.

The SEC's chief economist, Chester Spatt, delivered a speech entitled "Financial Regulation: Economic Margins and Unintended Consequences" at the Washington Area Finance Conference at George Washington University on March 17.

He made some interesting points, maybe some that we've all noticed before. For instance, with regard to the 1993 cap that was placed on the tax-deductibility of non-contingent executive compensation over $1,000,000; however, "firms substituted alternative compensation in order to be able to pay prospective employees their equilibrium compensation level. One could argue that an "unintended" consequence of such legislation was to increase executive compensation."

He wonders about the possible "unintended consequence" of stock options expensing:

"Because of the efficiency of our financial markets, I would not expect options expensing to lead to substantial changes in the valuation of companies that have significant option programs. However, one potential impact from options expensing and arguably an "unintended effect" may be to moderate the use of these grants in compensation programs by educating boards of directors as to the potential ex ante cost to these grants and removing the natural bias in favor of a compensation tool that was not reflected previously on the profit and loss statement."

Surely there will be some definitive academic study on the before-and-after prevalence of U.S. stock option grants once all companies are reporting on the same basis. (And that's still going to take some time.) For now, the anecdotal evidence - or at least the conventional wisdom - points to that unintended consequence: options grants are widely believed to be declining, in favor of more awards of restricted stock.

Then U.S. firms' treasurers are smilin', too. Or something like that.

Glenn R. Simpson reports in today's Wall Street Journal that a new study shows that American companies may been overly aggressive in their use of 12.5% Irish tax rate. The study, conducted by economist Philip Lane of Trinity College Dublin, indicates that U.S. firms may not have in fact had the actual physical investment in Ireland that they should have, in order to take advantage of the lower rate.

As you review the 10-Ks and annual reports, do a little reality checking yourself: if a firm has a low tax rate due to Irish tax rates, take a look at the segment information and see if the firm is predominantly invested/operates in the United States or countries other than Ireland. Might make for some interesting discussions with management if you find a relationship in the segment information that contradicts the information in the tax footnote.

Tried to get the report; as you might expect, Philip Lane's home page was timing out due to overload. Later, I hope.

* * * * * * * * * *

Speaking of the Wall Street Journal (online), anyone else but me notice that if you go to "Industry News" and then select "Accounting Industry", all the news stories that were once feeds from Dow Jones Newswires are gone? This seems to have happened since their revamp of the online Journal, and it doesn't seem to affect the other industries.

Maybe I'm the only subscriber who cares, but I used to find that incredibly helpful.

A couple of recent restatements ...

Calgon Carbon Corporation filed a non-reliance 8-K yesterday, for a total $1.4 million (pretax) understatement of expenses in 2005. Reason:

"The Company determined that it failed to record invoices for professional services in a timely manner totaling $0.6 million for the quarter ended March 30, 2005; $0.5 million for the quarter ended June 30, 2005; and $0.3 million for the quarter ended September 30, 2005."

No clue as to the nature of the professional services. The amended 10-Q shows that the adjustments knocked another 2 cents from net earnings per share for the nine month period.

CSK Auto Group filed a non-reliance 8-K yesterday, too, covering its financials from 2005 and 2004. Multiple reasons:

"... the accounting errors and irregularities relate primarily to the Company's inventories and vendor allowances, as follows.

1. In-Transit Inventory. The Company is investigating a potential overstatement ... It appears that at least $20 million of this inventory overstatement originated in periods prior to fiscal year 2002.

2. Other Inventory Accounts. The Company has identified certain costs included in its inventory, a portion or all of which appear to be improper. The aggregate fiscal year-end balances of these costs were approximately $13 million in fiscal 2001, $14 million in fiscal 2002, $28 million in fiscal 2003, $32 million in fiscal 2004 and $25 million in fiscal 2005...

3. Vendor Allowances. Certain vendor allowance receivables on the balance sheet at the end of fiscal 2004 that were refunded or written off in fiscal 2005 are being investigated. It appears that between approximately $4 million and $10 million of such receivables may have resulted from errors or irregularities in prior periods."

CSK Auto Group is still investigating the details of its problems; restatement forthcoming.

So - what's the common thread?

There are two of them. First, none of these problems related to exotic interpretations of accounting literature for derivatives, or pensions, or anything remotely complex accounting-wise. They related to failures of internal controls over basic transactions within each firm, the essential blocking and tackling that should take place every day. In both cases, the blocking and tackling didn't happen for months, even years.

Second, both of these firms have market caps below $700 million. They're examples of the kinds of companies that would benefit from "lighter regulation" sought by the SEC's Advisory Committee on Smaller Companies. And they both show why it's a mistake.

Last week, I mentioned General Motors' announcement of its expected delay in filing its 10-K. I noted, in the context of the 8-K only, its curious disclosure that the "misstatement related to the fact that GM's portfolio of vehicles on operating lease with daily rental car entities, which was impaired at lease inception, was prematurely revalued in 2005 to reflect increased anticipated proceeds upon disposal." In lease-speak, that means that the residual value of leased cars - representing the amount of money GM expected to get from end-of-lease disposal of cars returned to it -had been upped once in 2005 before it should have been. Now it's being written down.
The blogger known as "Iocaste" at Fantasy Life pointed to me that GMAC's 2004 10-K brings home the nature of the write-up/writedown a little more clearly:

"GMAC bears the risk of loss to the extent that the value of the vehicle upon remarketing is below the residual value estimated at contract inception. GMAC primarily uses published residual guidebook values in establishing standard residual values at contract inception. These projected values may be upwardly adjusted as a marketing incentive if General Motors considers an above-market residual appropriate to encourage consumers to lease vehicles. Such residual support by GM results in a lower monthly lease payment by the consumer. General Motors reimburses GMAC for its portion of these increased residual values, to the extent remarketing sales proceeds are less than the contract residual at termination."

Judging by that disclosure, GMAC starts out with one figure for residual values; if GM decides it needs to prod sales by offering lower lease payments, then an "above-market" residual is employed by GMAC to get juice flowing. In the end, if GMAC doesn't get the "above-market" residual (why would it? the market price is what it is), then GM is on the hook for the difference between what GMAC gets and what it recorded as residual values.

It sounds like GM is now taking action to clean up the portfolio values - probably a necessary step provoked by its efforts to shop around GMAC. Once you see this, you begin to wonder how much similar dross is floating around in the portfolios of other auto companies and other firms with captive financing subs.

In this case, you can relax and enjoy the peace and quiet.

In August 2004, the PCAOB released its first reports on its inspections of the Big Four auditing firms. The quality control issues it noted in those inspections remained private - unless the firms did not remedy them within twelve months. And apparently, they addressed them well; none of the gory details have ever been made public. The threat of public embarrassment is a pretty big carrot/stick.

On Tuesday, the Public Company Accounting Oversight Board (a subscriber to The Analyst's Accounting Observer) released two reports. One described its process for evaluating how well the previously-inspected public accounting firms have improved their quality control. (No link to this report; I'm afraid you'll have to look for it. One of those internet mysteries where the mere act of creating a link causes the browser to sizzle and fry.)

The second report is a bit more interesting; it details some of the steps taken by firms to improve their quality controls. Among them:

- changing the organizational structure so that there's separation of the audit performance function from responsibility for ethics, independence, client acceptance, and audit quality monitoring. (Seems so basic, you wonder why it had to be brought up.)

- adding internal guidance requiring more experience audit personnel review the contractst carry the most risk for material misstatement. (Another common-sense step.) - increasing the number and depth of the firms' own inspections and evaluations of audits. (This refers to the fact that audit firms have their own internal auditing functions; they inspect how effectively the firm has carried out their engagements.)- changing the way partners are compensated and promoted by increasing the emphasis on technical auditing skills and decreasing the emphasis on "rain-making."

- tightening up on the criteria for client continuation

There's plenty more, but you get the drift: what were once habits are now recognized as vices. The dog didn't bark this time; there's nothing to bark about. The firms kept their end of the bargain and straightened their respective houses. But let's hope the watchdog stays awake.