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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.
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| AAO Weblog (Public)
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Author: |
Jack Ciesielski |
Created: |
10/13/2006 2:54 PM |
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The AAO Weblog is a weblog published by Jack Ciesielski , dealing with accounting issues and news topics related to investment and finance. |
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CSK Auto: Follow-through
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By Jack Ciesielski on
9/29/2006 6:59 AM
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About six months ago, CSK Auto announced that they were investigating inventory and vendor allowance problems and issued the now-traditional non-reliance 8-K filing.
Yesterday, they released the preliminary results of their investigation. An excerpt from their most recent press release filed with yesterday's 8-K:
"Based on preliminary results of the investigation, the Company previously announced probable maximum estimated overstatements relative to its previously filed October 31, 2005 balance sheet of approximately $70 million in inventory and $12 million in vendor allowances. As previously reported, the Company also identified an estimated overstatement of between $3 million and $7 million of store surplus fixtures and supplies. In addition, it is expected that the restatement will result in material changes that both increase and decrease previously reported results of operations for the periods that will be restated. At this time, no facts have been developed that would indicate that any of the foregoing items would have a material adverse effect on historical revenues or cash flows or on the Company's ongoing or future business operations."
The company has yet to file financials for its 2006 operations. The problems noted above go back to 2003; the previously filed financials haven't been restated yet either, but they're pending. The company's president and its CFO, "as well as several other individuals in the Company's finance organization are no longer employed by the Company."
The item is a curiosity because none of these issues mentioned are at the cutting edge of accounting theory. We're talking about accounting for inventory, what to do with credits given by suppliers, and how to account for store fixtures - not exactly on the same level as accounting for fair values of derivative instruments. It's basic blocking and tackling for retailers. And it demonstrates the need for assessing controls involving basic blocking and tackling. The firm identified the issues in its first Section 404 review last year.
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The Cost Of Backdating
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By Jack Ciesielski on
9/28/2006 3:35 AM
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A study done by Bloomberg News on the price effects of backdating probes shows that the investigations have "cost investors $7.9 billion in market value." The article goes on to state the underperformance of the companies compared to their peers and/or the S&P 500 index. Maybe that shouldn't surprise anyone by this time; late in the article, there's an admission that "the market has a tendency to overshoot on fear." At least when you're talking about Apple, which has gone up 37% since dropping by 6% on the day its backdating probe was announced.
The article talks about the market costs of the options probes - but those change from day to day, and the memory of Wall Street is a funny thing. For instance, the article also notes that the impact on stocks at the time of the announcement has diminished: it's dropped in more recent announcements. The article mentions that the "average one-day loss for the first 30 companies to disclose investigations, from March 14 to May 25, was 2.9 percent, or 2.8 percentage points worse than their peers. The last 30 disclosures as of Aug. 31 prompted an average decline of 1 percent, trailing peers by 1.2 percentage points."
Chalk up market effects to evidence about poor controls, poor corporate governance, expected management distractions, or any combination of the above. Market effects might also include anticipated cash costs - but those are so fuzzy to predict, it's hard to believe they'd be currently well-incorporated into stock prices. And they're likely to be "sticky:" they're not likely to be incurred all at once. But incurred they shall be, and the markets might find more to dislike as they're more visibly quantified.
Some possible cash costs that the markets might not yet have fully digested (because they're still pretty much unknown):
Taxes. Finding out that options may not have been validly issued could negate past cash savings on income taxes. Filing amended past tax returns with evaporating deductions could lead to big cash payments - and it's nigh well impossible to guess how much from published financial statements.
Auditing costs. It's not clear how far back misstated financials will have to be restated, but for now, it's reasonable to expect that all material misstatements will be restated. The Commission has effectively warned companies to be very careful about making assumptions about how far back they need to go in restating, in this letter from Chief Accountant Conrad Hewitt issued last week:
"...The staff understands that errors related to the issues addressed in this letter may affect several years of filings, and that companies may believe that amending all of the affected filings is unnecessary. Companies that propose to correct material errors without amending all previously filed reports should contact the staff of the Division of Corporation Finance. No amendment of previously filed reports is necessary to correct prior financial statements for immaterial errors."
If it isn't immaterial, don't expect not to restate... get it? That's the message, it seems.
When the market gets hold of increases in audit fees for the examinations, there's bound to be the cost-versus-benefit kinds of stories in the media, apart from the "shareholder pocketbook" stories like this one. It'll be easy to put down the cost of the auditors: after all, they're part of the cost of restating financials that today's investors might rarely read. Maybe, maybe not. If a management team is still in place at a firm where the company engaged in option skullduggery ten years ago, that would seem to be information that a current investor would still be interested in knowing. Even if there's a complete turnover in the executive suite, today's investors would probably be interested in knowing about the extent of past transgressions: corporate cultures don't necessarily change in the space of ten years.
When it comes to restatements going back longer than just a few years, this is pretty much uncharted territory - it just hasn't been prevalent, at least to my memory. To get today's figures cleaned up, it might be necessary to dive into financials of ten years ago. The options problems being investigated involve plenty of specific documents that may no longer exist, and contacts with people who may have departed the companies - or even this world - long ago. Yet the current financials could still carry an impact from the proper accounting being applied ten years ago - and it isn't going to be cheap or easy to find out what that impact is. Do shareholders deserve to know? Yes. Should they complain about the cost? No. If something unfavorable to shareholders has occurred in a company in which they invest, they'd be foolish not to want to know. That's what the audit function is supposed to provide the shareholders, so they shouldn't have a problem with audit fee increases due to this activity. (If there's a problem with audit fees at all, it should be that they didn't reflect this kind of work ten years ago.)
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Overlooked Angles On The SEC's New Comp Disclosures
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By Jack Ciesielski on
9/27/2006 6:50 AM
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The new executive comp disclosures, effective for the proxies of the next wave of calendar year end filers, promise to bring some much-needed clarity to the subject so near and dear to the financial journalist community. And there are a few subtleties to them to which the press hasn't devoted much attention.
On Monday, John White, the SEC's Director of the Division of Corporation Finance delivered a speech to the "Practising Law Institute Fourth Annual Directors' Institute on Corporate Governance" on the new disclosures, shedding light on on some aspects of the disclosures that will impact managers and directors - in more ways than just the recitation of a comp figure, with the attendant "Holy Cow!" exclamation by proxy readers.
One change brought by the standard has to do with the new "Compensation Disclosure & Analysis" to be found in the proxy and 10-K. This replaces the old "Board Compensation Committee Report on Executive Compensation" with a "principles-based" disclosure about compensation. (White elaborated on the "principles-based" disclosures in a prior speech this month.) While the format itself will be different, it will also be a corporate disclosure - not a statement by the board's compensation committee. As a corporate disclosure, it will be subject to the CEO/CFO certifications that have brought changes in the "tone at the top," according to Chairman Cox. That increases the pressure on firms to actually produce robust, non-evasive disclosures - or face the stiff consequences of failure to fulfill SarbOx Section 302 obligations.
Another aspect of the new comp rules that don't get much airplay: the effect they'll have on directors. According to White, "Director compensation for the last fiscal year will now be required to be disclosed in a new Director Compensation Table (along with related narrative), which will be similar in format to the Summary Compensation Table that is the primary vehicle for disclosing the amounts of your executives' compensation. As with executives, companies will be required to disclose one total number for a director's compensation, which will include the dollar value of option grants to directors and perquisites, among other compensation."
As the H-P soap opera shows, there are all kinds of, shall we say, "interactions," among board members - and managers, too. The degree to which any interactions in any dysfunctional board might be affected by compensation should be clearer starting next year. It'll provide a rich arsenal of ammunition for the corporate activists.
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Seems Like Just Yesterday
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By Jack Ciesielski on
9/26/2006 3:24 AM
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A couple of news articles about a few denizens of the Enron era surfaced in the past week. You might not remember the name Jamie Olis like you'd remember Ken Lay, but he was a tax accountant with Dynegy who helped arrange that firm's "Project Alpha" to inflate revenues and cash flows using swaps, SPEs and secret side agreements. After the investigation, Olis received a lot of attention for the harshness of his sentence: 24 years. That sentence was tossed out last year in the U.S. Court of Appeals, for being unreasonable. He's been resentenced (by the same judge who sentenced him the first time, Judge Sim Lake) to a six year sentence. Lake also managed the Lay and Skilling trials.
Speaking of Skilling - he's in the news again. Sadly, this time for being ticketed for the misdemeanor of public intoxication as his sentencing date looms on October 23. Meanwhile, fellow Enron perpetrator Andrew Fastow promotes a button-down, nice guy image of a helpful community volunteer as his sentencing date approaches.
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Cox Testimony: A Hint Of Exams To Come
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By Jack Ciesielski on
9/25/2006 6:39 AM
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SEC Chairman Christopher Cox testified last Tuesday on the impact of the Sarbanes-Oxley Act before the U.S. House Committee on Financial Services. The testimony got little mention in the press, and what mention it did receive focused on Cox's remarks about the costs of Section 404 examinations. (This article, for instance.)
True enough. His testimony did include a recap of the SEC's efforts to effectively neuter Section 404 for small companies (those with a market cap under $75 million), including their most recent proposal to extend the date by which a firm's auditor must attest on internal controls to the first annual report filed for a fiscal year ending on or after December 15, 2008.
It's hard to accept the reasoning in that action, and it's hard to believe that the implementation of the evaluation of internal controls has been so problematic in small companies. They certainly can't be as complex as their grown-up brethren; the issue is probably that they simply don't have adequate controls and auditors must extend their testing further in expressing an opinion on the financial statements as a whole.
Back to the Cox testimony. What's been under-reported: Cox offered an understated rebuttal to those carping critics citing the recent large IPO listings in foreign markets as evidence that SOX 404 requirements have made American capital markets "non-competitive". (Never mind that investment banking fees can be twice as high in the U.S. compared to Europe.) He commented that some of the same countries enticing firms to list on their home exchanges as a way of avoiding SOX are, in fact, adopting some of its provisions. Some examples:
"Governments in the major markets around the world have established independent auditor oversight bodies like the PCAOB. For example, the European Union recently adopted a directive requiring all EU member states to create an auditor oversight body..."
"Other major capital markets have also recognized the conflicts of interest that some non-audit services create, and the need to place restrictions on these services to improve audit quality. The European Union, the United Kingdom, France, Hong Kong, China, Japan, Australia, Canada, and Mexico have all passed reforms requiring mandatory audit partner rotation, although they vary regarding the details about how this rotation works."
"The United Kingdom, Hong Kong, Australia, Canada, and Mexico have all introduced reforms since 2002 requiring that all members of the audit committee be independent of management."
"A number of countries have even adopted requirements similar to the first half of the controversial Section 404 of the Sarbanes-Oxley Act, which requires management to do its own assessment of internal controls. Several countries, including the United Kingdom, Australia, and Hong Kong, have adopted a comply-or-explain approach to a management assessment. Japan, France, and Canada all now have legislation or regulations requiring a management assessment of internal controls."
Cox also defended the effect that the Act has had on the "tone at the top," saying that the Act's requirements for CEO and CFO certification of the financial statements has stopped corporate buck-passing. He testified that the Act has improved the audit process and improved audit committees.
He also testified that while "[w]e have also become convinced that there are no irreparable problems with Section 404 implementation," the SEC would work with the Public Company Accounting Oversight Board to mitigate the implementation issues that have caused small companies to gag at the prospect of implementing internal control reviews. Cox addressed the next SEC inspections of the PCAOB, hinting that they'll focus on whether the PCAOB is looking for auditor effectiveness in carrying out their inspections of public accounting firm audits of public companies. The SEC's concern is that audits are being done without wasted time and effort:
"We anticipate that the SEC staff's next inspection of the PCAOB will focus on the PCAOB's own inspection program for registered audit firms. In particular, the staff will likely focus on the PCAOB's inspections of audits under PCAOB Auditing Standard No. 2.
This authority to inspect the PCAOB is an important aspect of the Commission's general oversight under Section 107(a) of the Sarbanes-Oxley Act. By focusing our next inspection of the PCAOB on its largest program area  inspections of registered public accounting firms under Sarbanes-Oxley 404 and Auditing Standard 2  we hope to achieve greater compliance with the Commission's and the PCAOB's own guidance that these audits be risk-based and cost-effective."
In short, carrying out the task of auditing public companies in accordance with the standards set by the PCAOB won't be good enough - they have to be efficiently done as well. Considering that the vast initial job of documenting control systems and getting them in order is now out of the way - at least, for firms above the $75 million market cap threshold - it's reasonable to expect that auditors are moving along the learning curve. We'll see when the PCAOB completes its inspections.
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