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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.

A few years ago, the SEC used to have "We are the investor's advocate" plastered in various prominent spots of its website - like the home page, for instance.

No more. The SEC has become kinder and gentler, it seems, with bigger interests than just advocating for investors. I mentioned Commissioner Paul Atkins' speech last week, the one where he continued to bash Section 404 costs while praising efforts at making Auditing Standard 2 less onerous. I forgot to mention this snippet:

"The SEC is very concerned about maintaining our capital markets as an attractive place for investors to invest. In fact, we are charged by Congress to look after not only investor protection, but also competition and efficiency of the financial marketplace and ease of capital formation. We must ensure the integrity of our markets so that investors have confidence that they will be treated fairly. At the same time, our regulations must not price those very investors out of our markets through burdensome regulations or eat up the fruits of their investments through nonsensical mandates."

"Charged by Congress to look after not only investor protection but also competition and efficiency of the financial marketplace and ease of capital formation?" Well, yes. And he's right; it's in black-and-white in the 1933 Act. But the 1933 Act presents it in a slightly different tone:

"Whenever pursuant to this title the Commission is engaged in rulemaking and is required to consider or determine whether an action is necessary or appropriate in the public interest, the Commission shall also consider, in addition to the protection of investors, whether the action will promote efficiency, competition, and capital formation." [Emphasis added.]

Notice what comes first: the protection of investors. The rest is secondary. Commissioner Atkins' statement sounds like he's channeling the Bloomberg/Schumer report or the Paulson Committee report more than echoing William O. Douglas. This reference to Douglas comes from a 1995 speech by Arthur Levitt:

"One of my predecessors, later Supreme Court Justice, William O. Douglas described our special role in this way: "We've got brokers' advocates; we've got exchange advocates; we've got investment banker advocates; and we are the INVESTOR'S advocate.""

Maybe the pendulum hasn't swung completely the opposite way from the reform era after Enron - but it feels like it's almost there. I offer this list of "Top Ten Signs the Pendulum Has Swung" compiled by David Katz at CFO.com so you can at least get a good laugh out of the current deregulatory folly.

And they're not the only ones setting the controls of the WABAC machine for the early 1990's.

Sherman and Mr. Peabody, the dog and his boy who went back in time to fix mistakes in history with the aid of the WABAC machine (as in "wayback"), would be busy with backdating right now. If they were around.

In this nonreliance 8-K, game maker Activision took its financial information from 1992 to 2006 out of service. No hints as to the amount of compensation adjustment, nor tax effects, nor specific years that were most affected by improper dating. Just the promise of restated financials ahead. Instead of "back to the future," we're looking "forward to the past."

Also spending time with the WABAC machine: Trident Microsystems. According to this 8-K, they'll be restating from 1994 to 2006, adding an estimated $40 to $50 million of incremental compensation expense. Actual results may vary.

Another trip forward to the past will be taken by Actel. In this nonreliance 8-K, they outline their plans to restate from 1996 to 2006. No clues as to amounts.

This will be a pretty taxing annual report season for some analysts. Not only will there be plenty of current history to digest, there'll be tons of rewritten history to chew on as well.

From a former Arthur Andersen employee, regarding my post on the Bloomberg/Schumer report:

I feel compelled to respond to your comment about Arthur Andersen: “remember the shredding of evidential workpapers?”

No audit workpapers were shredded, and the DOJ never claimed that workpapers were shredded. The shredded documents were correspondence files and such; documents that did not belong in the workpapers and were never part of the workpapers. The audit workpapers were intact.

As to your comment about flawed audits, that is subjective (the nature of documents is objective). I would only observe that the record of the numerous investigations over the past five years reveals a pattern of deliberate withholding of key transaction details from the auditors, aided and abetted—knowingly—by a host of blue-chip commercial and investment banks.

Thanks for the clarification: I changed the post to read "remember the shredding of correspondence files?"

Aside from that - there's nothing else to change. My point is not to trash Andersen, or its people - my point is that history should not be revised to read that Andersen was done in by litigation. It wasn't.

As for "flawed audits" being a "subjective comment" - no. The outcome of the audit in question is not subjective - it's an objective fact, as well as other Andersen audits of the time. Good audits don't have those outcomes. My point was - and is - that there was more at work in the demise of Andersen than litigation - it started with the audits they could have done better.

That post did not start as an attack on Arthur Andersen, and this one is not going to turn into one, either. But you also cannot say that this was a firm doing everything right and was unraveled by litigation.

Here it is.Last week's scribblings in handy podcast form.

Commissioner Paul Atkins delivered a speech at the Corporate Directors Forum and as usual, unleashed himself on one of his favorite topics: Section 404 of the Sarbanes-Oxley Act. Atkins, like the Paulson Committee and Bloomberg/Schumer, worry about the US markets' place in the world rather than investor information - as if the two were mutually exclusive.

His speech contained the usual complaints about the "costs" of 404. (As if there are no costs to investors or the economy as a whole for audit failures.) He cited in particular the costs incurred for compliance procedures performed by firms that were subsequently ignored by auditors. Seems like the answer is to make the auditors snap to attention, not gut the rules.

While the PCAOB and the SEC continue to revise Auditing Standard 2, it's good to note that their efforts aren't wasted on Commission Atkins:

"I think almost all players in this debate have recognized the flawed approach that was initially rolled out. Last month, the SEC proposed additional guidance for management's assessment of internal control. Around the same time, the PCAOB proposed replacing AS 2 with a new audit standard, AS 5, for an outside auditor's attestation of internal controls. Far from being a rollback or lessening of standards, I think the new proposals go a long way towards implementing the original vision of Sarbanes-Oxley. I look forward to seeing the comments on these proposals."

We'll see how satisfied everybody is with the new, improved AS 5 in about another month. While Atkins notes that Sarbanes-Oxley has been around for almost five years (its birthday is in July), there have only been two complete 404 inspection seasons. (No - wait a minute. Those small cap firms that never seem to have control problems are still being granted waivers.) Simply by virtue of the learning curve experienced by most sentient human beings, the process has to get better. Revising the audit guidance is part of the learning process. But it will be interesting to see if the critics are content with evolutionary change and continue to demand more "relief."

Upfront disclosure: the PCAOB is a subscriber to The Analyst's Accounting Observer. (But that doesn't mean I know any more about them than you.)

The PCAOB issued an unusual kind of report this week - not one about its findings of quality control at an auditing firm, but a sort of blanket set of observations corralled throughout all of their examinations. Their conclusion auditors don't do what they should be doing to stem fraud in six different areas. A few nuggets from their findings:

Auditor's Overall Approach to the Detection of Financial Fraud. Auditing standards require auditors to make informed judgments about the tests to perform to address risks related to fraud. Finding: "...PCAOB inspection teams have observed, however, that auditors often document their consideration of fraud merely by checking off items on standard audit programs and checklists."

Brainstorming Sessions and Fraud-Related Inquiries. PCAOB auditing standards require audit teams to hold "brainstorming sessions" to consider how badly financial statements could be warped by a dishonest management, while setting aside their existing beliefs about management integrity. Finding:"... PCAOB inspection teams have noted instances of failures to comply with this aspect of the standard. In particular, PCAOB inspectors have (1) identified audits in which the audit team was unable to demonstrate that brainstorming sessions were held; (2) identified audits in which the audit teams' brainstorming sessions occurred after planning and after substantive fieldwork had begun; and (3) identified audits in which key members of the audit team did not attend the brainstorming sessions."

Auditor's Response to Fraud Risk Factors. Auditors are supposed to respond to risk factors they've identified by customizing their audit approach to the situation. But if they aren't doing the work to identify the risks, how can they follow up? This finding of the PCAOB is even worse: "... PCAOB inspection teams have observed instances of auditors failing to respond
appropriately to identified fraud risk factors. Inspection teams also observed instances in which auditors examined transactions warranting further fraud risk consideration, but for which there was no evidence that the auditors had considered any associated fraud risk factors."

Financial Statement Misstatements. If auditors find misstatements, they're required to evaluate whether they're the possible result of fraud. Finding: "PCAOB inspectors noted instances in which auditors failed to properly calculate planning materiality ... As a result, certain uncorrected misstatements were not evaluated, or were not evaluated appropriately, both individually and in the aggregate, with other misstatements because the summary schedule was incomplete. The inspection teams also observed that some auditors did not fulfill their responsibility to investigate identified departures from generally accepted accounting principles to determine whether such departures were indicative of fraud."

Risk of Management Override of Controls. Auditors are required to examine journal entries and other adjustments to financial statements to see if they're legitimate. There's a term in financial reporting called "top-side" adjustments: the ones that take place between the published financials and the underlying internal financial reporting, and they're especially critical to an audit. They represent evidence of a management's last chance to change the recording of reality done by the financial reporting system before the statements are issued. Finding: "...some instances it did not appear that the auditor had appropriately addressed the risk of management override of controls with respect to journal entries and accounting estimates. Also: "...PCAOB inspection teams observed that some auditors have failed to test, or failed to document their testing of, management's assumptions and other aspects of issuers' accounting estimates."

Other Areas to Improve Fraud Detection. PCAOB inspection teams also found deficiencies in other important audit areas that might help detect fraud, such as confirmations (for instance, accounts receivable are confirmed by auditors with outsiders to see if they're part of real sales transactions); analytical procedures (looking for odd relationships between accounts); and review of interim financial statements.

Is their report an indictment of the auditing system? Don't think so. If all these problems were found en masse at one audit firm, yes, you'd have grounds for closing up the shop. But the report doesn't read that way: it's a collection of observations by various inspection teams, and likely issued as a reminder to audit firms at the top of the audit season to stick to their standards. Look sharp!

"Chairman Bob" will be sticking around for another five-year term. Be glad.

With leasing, fair value projects and Phase 2 of benefits accounting on the agenda, ten more years wouldn't be inconceivable.

On top of the Paulson Committee recommendations comes another similar report on how miserable life has become in a world where accountability now matters. It's the report prepared at the request of New York Mayor Michael Bloomberg and Senator Charles Schumer, entitled "Sustaining New York's and the US' Global Financial Services Leadership."

I haven't gotten to read the whole report yet, but a few things from the executive summary make me wonder. Like this for instance, regarding how the research for the report was done:

"... a McKinsey team personally interviewed more than 50 financial services industry CEOs and business leaders. The team also captured the views of more than 30 other leading financial services CEOs through a survey and those of more than 275 additional global financial services senior executives through a separate on-line survey. To balance this business perspective with that of other constituencies, the team interviewed numerous representatives of leading investor, labor, and consumer groups."

If you interview, through one means or another, 355 financial services industries CEOs, business leaders and other financial services senior executives, you can be pretty sure you're going to hear a consistent message: reduce regulation. How many investors were consulted "to balance this business perspective?" Can't tell from the above statement, and I couldn't find it anywhere in the document, but I'd suspect it wasn't enough to really "balance" things.

Predictably, the report recommends that the SEC and PCAOB "provide clearer guidance for implementing the Sarbanes-Oxley Act." Never mind that they've been clarifying it over the last few years and a revised, lighter-weight Auditing Standard 2 is in the works. They also call for the SEC to consider letting small firms opt out of Sarbanes-Oxley requirements for real instead of the "de facto opting out" by stalling the implementation date - something they've been doing ever since the law was enacted. Ditto for foreign firms.

Another predictable recommendation: "implement securities reform." There's concern that the auditing industry could not afford to lose another of the big auditing firms to litigation, and the report cites Arthur Andersen as an example. Fine to cite it as an example of a loss, but don't confuse it with losing it to litigation. Andersen didn't dissolve from the lawsuits; its flawed auditing was its first stumble and the indictment by the Department of Justice for obstruction of justice (remember the shredding of correspondence files?) was the deathblow.

There's a lot of talk about limiting auditor liability right now, and it strikes me as a little contradictory. Often, companies' finance and accounting staffs bemoan the lack of slack on the part of outside auditors in the Sarbanes-Oxley era. If the audit environment truly has turned in favor of auditors - if they really have some power now and can perform higher quality audits - then their legal exposure should be diminished in an era of stricter controls. Why do they need a liability cap now? They don't. But going forward, maybe they'll need it in a wilder environment that could occur if the roll-back of Section 404 examinations actually happens.

The entire thrust of the report is to preserve the jobs and output of the financial services industry. But it seems like it focuses only on the banking side of the financial services industry and the concern with listings. Everything that can be imputed to regulation is named - but there's little blame for one possible problem with listings. That's the fact that investment banking fees for floating an IPO in the US are about twice as high as in the UK. I don't think that's mentioned in the study. See the report entitled "The Cost of Capital: An International Comparison," prepared by Oxera Consulting at the London Stock Exchange's website.

Last Wednesday, the SEC filed a civil action against three former officers of ConAgra Agri Products Companies, a unit of ConAgra: former president and COO, James Blue, former North American operations president Randy Cook, and former controller Victor Campbell.

The trio is charged with quite a bit. The suit alleges they perpetrated fraudulent accounting practices including improper revenue recognition for deferred delivery sales and linked rebates from suppliers; omission of bad debt expenses when incurred; and flawed revenue recognition related to advance vendor rebates. Outcome: ConAgra overstated its income before income taxes by about 7.35% in 1999 and 7.85% in 2000. At the segment level, operating profit was overstated by 16.36% in fiscal 1999, and 34.97% in fiscal 2000.

All three defendants benefited from their actions by receiving bonus compensation based on the inflated earnings. The SEC's complaint holds many details of their handiwork, but here's an abbreviated version:

The improper revenue recognition for "deferred delivery sales" is for items sold, but not yet delivered; they were still in possession of goods at the end of the periods in question. This is the "bill and hold" revenue technique made famous by Sunbeam Corporation in the 1990's. It can be accomplished legitimately, but it should be rare: Staff Accounting Bulletin 101 describes the conditions necessary to pull it off properly. Not so in this case - and compounding the faulty recognition, UAP received vendor rebates based on the inflated sales, which further increased revenues. (Wrongly.)

More bad accounting: the provision for bad debts was not stoked while receivables soured . In those two years under examination, the firm avoided $35 million of bad debt expense. Even a plan to write down uncollectible receivables over five years (which is still a violation of GAAP) was rejected by the principals as being too costly to earnings. Finally, the trio was involved with negotiating rebates from vendors in advance of fulfilling the conditions for actually earning them (like selling the vendors' products) and then recognizing them as revenue.

The unit was offloaded to Apollo Management in 2003. The Commission's investigation continues. What's interesting is that these machinations aren't based on some twisted interpretation of an exceedingly complex accounting standard. No, they're just basic blocking-and-tackling issues that had been warped into a work of financial fiction. Bad incentives may have made for bad accounting.