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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.

After this post, a short hiatus begins for The AAO Weblog - just until January 2, 2007.

Just in case you don't get the bestseller that was on your Christmas wish list, here's something to blunt your disappointment. It's the Division of Corporation Finance's "Current Accounting and Disclosure Issues in the Division of Corporation Finance." There's an accounting fix in it for you on almost every page over the next week!

Best wishes for the holiday season, and for 2007!

Hey, I just found out: Christmas comes this weekend!

So, instead of reading and writing, I'll be contributing to the welfare of all of us - by parting with greenbacks and plastic-backs at the malls.

Back tomorrow.

Just to clarify a point or two on yesterday's post about the possible "re-imagination" of UnitedHealth's earnings history between 1994 and 2005...

What happens here could set a precedent for the way the remedies from the other investigations are handled. So, let's hope that the Office of the Chief Accountant thinks this one through before signing off. There's an important question to be addressed here, specifically, what's the right way to handle new accounting treatments that can be handled retrospectively? Are investors better served by "re-imagining" history as if the new accounting treatment is handled all the way back to the beginning of time (like in the fictional environments of James Bond and Batman)? Or are such treatments misleading?

(Of course, little is known to date about the cash effects stemming from tax consequences. They're far from unimportant - but we're concerned with how operating performance has been portrayed and will be portrayed.)

When UnitedHealth chose to adopt the modified retrospective method of reporting stock compensation under Statement 123R on 1/1/2006, it was taking the accounting high road. Because of the awkward history of the stock compensation standard (optional adoption, with pro forma footnote info required for all), the FASB allowed firms to retrospectively adopt the recognition of stock compensation expense for all periods presented in the financial statements. That was NOT contemplated to be a twelve year stretch; I think that the typical three-year presentation is what the Board had in mind.

That interpretation is not likely to be construed by many firms other than UnitedHealth. It might interpret the retrospective provisions that way only because it chose the modified retrospective adoption method in the first place, which was a rarity among firms. If a firms elected to adopt Statement 123R under the modified prospective method (in other words, burdening future earnings with the nonvested fair value of option grants plus future grant fair values), they have no basis for trying to go all the way back to the beginning of their option problems in presenting a revised history. They never had an entry point for revising the past in the first place.

When a firm like UnitedHealth contemplated its policy of stock option compensation in the 1990's, it consciously chose to adopt APB Opinion No. 25 - and misapplied it. When revising the history, it should show the effect of that conscious decision, correctly applied. To wipe out the history of that decision and its consequences with a favorable accounting treatment (the 123R results cost less than the correct application of Opinion 25.) When they chose to adopt Statement 123R on a modified retrospective basis, they knew that they were getting a three year retrospective treatment - another conscious decision. So, a fair resolution would show APB 25 treatment, correctly executed, up until 2002, with the retrospective application of Statement 123R in 2003 - the beginning of the retrospective period for Statement 123R application under their decision to present history in that fashion, before they learned there was an upside to having taken the high road over a decade earlier.

"Assures great, less working"...

Hmm. Don't think it'll work in an ad. But the PCAOB's proposal for the replacement of Auditing Standard 2, with its lightening of audits of internal controls, has arrived. Link here.

Seen Casino Royale yet? The hook is that it's the first Bond movie in a freshening of the franchise. Instead of trying to extend the existing franchise under the same logical (maybe) framework as the previous Bond movies, this one starts over with James Bond in 2006 on his first mission. Result: one of the best Bond movies I've seen. And it seems like lots of ticket-buyers agree with me.

The "re-imagining" gimmick worked for Batman, in 2005. It worked for Superman earlier this year. Word is that it's going to be applied to the original Star Trek franchise, too. (Ben Affleck as Mr. Spock? Just plain wrong, on soooo many levels.)

Taking its cue from the movies, it looks like UnitedHealth may be re-imagining its stock compensation as well.

In the whopping 8-K filed in conjunction with its investor conference, UnitedHealth supplies answers to some of the stock option questions investors have ached for. The results of their internal investigation by Wilmer Cutler Pickering Hale and Dorr are in, and they're requesting "a consultation on certain interpretive issues with the SEC's Office of the Chief Accountant." What those interpretive issues might be aren't clear - but if a firm revokes the reliability of its published financial statements from 1994 to 1996, you'd have to suspect that the number of financial statements to restate might be one of those issues you'd like to run by the SEC before you find out too late that you didn't restate sufficiently far back. Continuing the movie analogy, that revocation effectively wipes out the old franchise, setting the stage for its "re-imagination."

As for the amounts of the stock compensation to be revised:

"The Company analyzed the accounting impact under two methods: its former accounting method under APB 25, and its current accounting method under FAS 123R. Management estimates that the aggregate amount of pre-tax non-cash charges for stock-based compensation expense for the period 1994 – 2005 determined under APB 25, the Company's former method of accounting, ranges from $1.5 billion to $1.7 billion.

On January 1, 2006, the Company adopted FAS 123R using the modified retrospective transition method, under which all prior period financial statements were restated to recognize compensation expense in the amounts historically disclosed under FAS 123. Under this current accounting method, management estimates that the aggregate amount of pre-tax non-cash charges for stock-based compensation expense ranges from $400 million to $600 million for the period 1994 – 2005 and from $25 million to $60 million for 2006."

That's where the bulk of the re-imagining comes in. If UnitedHealth restates all years from 1994 to 2005 with proper application of the compensation standard it chose to use during that period, the pre-tax compensation to be recognized is $1.5 billion to $1.7 billion. Presumably, it chose to use that method because it thought it could record less compensation expense than if it used the theoretically preferable method, Statement 123 and its sequel, 123R. (Yes, it's a presumption. But that was pretty much the way stock compensation was considered by firms in that era.)

Now that the company has thoroughly vetted its option compensation practices for the period, it finds that its option compensation would be less under Statement 123R. Which one will it use?

The company was required to adopt Statement 123R on January 1, 2006. To its credit, the company elected to apply the modified retrospective method of adopting the standard, which would restate all periods presented in the financials as if 123R had been in effect. At that time, it's doubtful that anyone considered that "restating all periods presented" would extend back to 1994. That wasn't contemplated in the standard; now that the company might be facing that task, one wonders if they'll go that route. And if the Office of the Chief Accountant will go for the idea.

One other interesting nugget from the company's above disclosure: it says that the 1994 - 2005 pretax compensation under Statement 123R was in the range of $400 million to $600 million. Go back to the footnotes for the now-invalid 2005 10-K, to see what the unrecognized comp was under Statement 123 for just the prior three years: $160M in 2005, $132M in 2004, and $122M in 2003, for a total of $414 million aftertax compensation. Gross it up for a 35% assumed tax rate and you get a pretax figure of $637 million. That's just for three years, not the entire period between 1994 and 2005. While Statement 123 and Statement 123R are different standards, the differences aren't major in the areas of valuation and recognition. If UnitedHealth goes the route of re- imagining their performance for that period using Statement 123R, hopefully, they'll have some really good disclosures about their calculations.

Last Thursday, the Public Company Accounting Oversight Board issued its report on its 2005 inspection of PricewaterhouseCoopers.

It found that the firm's quality control was lacking in some audits: revenue and receivables at one audit client were inadequately tested, for one example. When the auditors repaired their audit, they increased the confirmations of accounts receivable by a factor of ten. On other engagements, the firm had failed to test impairment charges, various aspects of inventory and fair values of investments. PwC acknowledged the deficient audits and remedied them.

One could look at the report - and the one issued on Deloitte & Touche last week as well - and get the idea that the Big Four are out of control. And certainly, it's bound to be spun that way in the press.

No apologies here for their mistakes - they don't even sound like they're failures involving extremely vexing issues. But it's not an unfair question to ask all involved: what do you expect a regulator like the PCAOB to do? How can you expect them to inspect the Big Four each year and NOT find something? After all, their existence has to be justified as well - and if there are tens of thousands of audit engagements occurring each year, they're not all going to be pristine. One would believe there's plenty of meat for the PCAOB to chew if it wants to find it.

The fact that there's a PCAOB inspection lurking in the bowels of each Big Four firm each year probably raises the quality of each employee's work over what it would be in the absence of an inspection machine. But just because the PCAOB doesn't bring one member of the Big Four to its knees each year doesn't mean it's not doing its job, either. Hopefully, if one of the Big Four goes off the rails into a swamp of total audit sleaze, the PCAOB mechanism is there to get them back onto the rails. Because it hasn't happened yet, investors should be glad.

The SEC voted on Wednesday to "propose interpretive guidance for management to improve Sarbanes-Oxley 404 implementation."

The actual proposal isn't yet posted to the SEC's website, but you can get the drift from the press release: more judgment will be exercised in what to test (as it always has been allowed, really) with an emphasis on risk and materiality. The proposal intends for management to:

1) Evaluate the design of the controls to determine if it's reasonably possible that a material misstatement in the financial statements wouldn't be contained in a timely manner.

2) Gather and analyze evidence about the operation of the controls being evaluated based on a risk assessment of those controls.

Now that those principles will be spelled out in black and white (actually, making them rules - watch out what you wish for!), then managers and their auditors might feel more comfortable about actually exercising judgment. Maybe.

The proposed document intends to be more specific about how to handle four problem areas the SEC has identified in existing 404 examinations: identification of risks to reliable financial reporting and the related controls; evaluation of the operating effectiveness of controls; reporting the overall results of management's evaluation; and documentation.

All to be developed in coordination with the PCAOB as it reviews auditing standards for the same kind of streamlining.

It's kind of ironic that more rules are being written to espouse the principles built into the existing standards. You almost have to believe that as the SEC and PCAOB write more such "principle-based guidance," there'll be more and more requests for "examples." This, as we head into the third season of internal control reviews - and farther down the learning curve.

Back at last from the AICPA SEC/PCAOB Conference ... and a good time was had by all.

Well, at least by me. While it may sound like a mundane affair, it's good to see so many faces that you don't see any other time of year. And good to actually meet some of the people who read this blog. (Thanks for introducing yourselves. And thanks for reading.)

And what could be more fun to discuss around the holidays than accounting, auditing and ... XBRL?

Whew. I need some real holiday cheer, and quickly.

This will be a brief post, even though there are so many interesting things happening this week: the Fannie Mae action against KPMG, the Section 404 revisions for small companies, and Google's online auction plans for employee stock options to name just a few. But ... there's a piece about the conference to write for the subscribers to The Analyst's Accounting Observer.

Anyway - I hung around until the bitter end of the conference hoping to glean a nugget or two about the direction of XBRL. More accurately, I should say I was interested in the velocity of XBRL. The direction is well-known, but it's the speed - and the speed bumps - that we don't know enough about yet.

By 4:30 PM on Day 3 of the conference, I think there were more members of the XBRL panel than there were members of the audience; had to be tough on the panel, but it's not supposed to be easy being an evangelist, I guess. I should mention that the representative from United Technologies, John Stantial, made a really effective case for XBRL usage within a firm. John also urged analysts to "pull on their companies" to use XBRL, instead of having the SEC "push XBRL onto registrants."

Commendable idea, but there's still a nagging lack of readily available (read: free, at least for a trial) front-end software to give analysts and investors something with which to noodle around the XBRL-ified data. Here's a start: the SEC has an experimental reader available for the public to use at this link. Don't get your hopes too high: it's only a start. I spent a few minutes with it; all I'll say for now is that it doesn't reveal the full power of XBRL as claimed by its proponents. But you might want to bookmark the site if only to check back once a month to see if there's a pickup in XBRL's velocity.