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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.

The Notice of Federal Advisory Committee Establishment and Notice of Meeting for the SEC's new "complexity-killer committee" has been filed; link here.

The composition of the committee could be finalized in the next 15 days. First meeting will take place on August 2, and all meetings will be webcast. According to the notice, when the committee files its charter, the areas expected to be considered in the its mission are:

  • the current approach to setting financial accounting and reporting standards, including (a) principles-based vs. rules-based standards, (b) the inclusion within standards of exceptions, bright lines, and safe harbors, and (c) the processes for providing timely guidance on implementation issues and emerging issues;

  • the current process of regulating compliance by registrants and financial professionals with accounting and reporting standards;

  • the current systems for delivering financial information to investors and accessing that information;

  • other environmental factors that may drive unnecessary complexity, including the possibility of being second-guessed, the structuring of transactions to achieve an accounting result, and whether there is a hesitance of professionals to exercise judgment in the absence of detailed rules;

  • whether there are current accounting and reporting standards that do not result in useful information to investors, or impose costs that outweigh the resulting benefits (the Committee could use one or two existing accounting standards as a “test case,” both to assist in formulating recommendations and to test the application of proposed recommendations by commenting on the manner in which such standards could be improved); and

  • whether the growing use of international accounting standards has an impact on the relevant issues relating to the complexity of U.S. accounting standards and the usefulness of the U.S. financial reporting system. All stuff that's been discussed in the accounting and finance world, and if major actions are taken on any of them, it could change life as we know it for investors, preparers and auditors. Anybody in those three categories should pay close attention to the workings of this committee.

  • I'm pleased to have The AAO Weblog mentioned (positively) in The CPA Journal, published by the New York Society of CPAs. It's in article entitled "Introduction to Accounting Blogs" by Susan B. Anders, a professor of accounting at St. Bonaventure University.

    "Ciesielski creates postings almost every day, sometimes on multiple topics. Unlike many personal blogs, the AAO is fairly sophisticated and professional in appearance."

    Lofty compliments. I'll do my best to keep earning them. Thanks!

    Yesterday, SEC chairman Christopher Cox held a press conference to announce the formation of an advisory committee whose mission is to 1) study complexity in financial reporting and 2) make financial reporting more understandable to investors. (Press release link here; webcast link here.)

    The committee will be chaired by Robert Pozen, Chairman of MFS Investments, and formerly vice chairman of Fidelity Investments. Over the next few weeks, 13 to 17 more members will be added. The committee is expected to take a year to develop its recommendations.

    According to the press release, the areas to be studied:

  • the current approach to setting financial accounting and reporting standards;
  • the current process of regulating compliance by registrants and financial professionals with accounting and reporting standards;
  • the current systems for delivering financial information to investors and accessing that information;
  • other environmental factors that drive unnecessary complexity and reduce transparency to investors;
  • whether there are current accounting and reporting standards that impose costs that outweigh the resulting benefits, and
  • whether this cost-benefit analysis is likely to be impacted by the growing use of international accounting standards.

    Though not mentioned in the press release (and I don't remember it in the webcast), the effort seems to be a parallel to Treasury Secretary Henry Paulson's plans for streamlining capital markets regulation.

    One wonders: is this an attempt to speed up the adoption of international accounting standards in the United States? Will the committee recommend swapping out parts of US standards with IFRS comparables? Will anyone care? (Just kidding.) One would hope though, that when they study "other environmental factors that drive unnecessary complexity and reduce transparency to investors," they take a good hard look at the tort system and the reasons why auditors and accountants always request ever more-detailed guidance from standard-setters. That builds up complexity quickly. The cost-benefit analysis angle should be interesting also; that's a new-found mantra in criticisms of the FASB and SEC. You can hear an echo of it in the comments of Columbia Business School's Glenn Hubbard in this Wall Street Journal video. More to come as the committee strikes up a beat.

  • Yesterday, the SEC settled charges with International Business Machines for a sham transaction conducted with Dollar General in 1999 and 2000. It's a good reminder of the Wild, Wild 1990's because it contains many ingredients of the accounting games of those days: pay incentives that could be gamed through accounting manipulation, loans disguised as revenues, side agreements and avoidance of writedowns.

    Where to begin? The SEC's complaint in the matter would help. It seems that in 1999, an enterprising IBM executive by the name of Kevin Collins persuaded Dollar General to lease new cash registers from IBM for $10 million over a few years. Not good enough: he wanted to accelerate the transaction through the end of 2000 - when it would have a favorable effect on IBM revenues AND his bonus. Dollar General balked because the acceleration of the register rollout would force them to write down the existing registers and take a charge. This became known as their "book value" problem.

    Collins hatched a plan for IBM to "buy" the cash registers back from Dollar General, and work the buyback price into the contract for the new registers, effectively doubling the price of the new computers from $10 million to $20.5 million. Given that there was no real purchase of the old registers and no intent to do anything with them after the "purchase;" the incremental dollars in the lease contract were really a loan, not revenue. IBM presented the transactions properly in their financials, but certain individuals benefited from having their bonuses calculated on the higher figure. One of them was Collins: 50% of his bonus was attributable to the Dollar General gig. As for Dollar General, the transaction enabled them to report pretax income 6.5% higher than it should have been stated.

    In the end, Collins agreed to the entry of a final judgment permanently enjoining him from "aiding and abetting violations" like these, and subject to court approval, will pay $95,000 in fines, interest and penalties.

    How about IBM? In a separate proceeding, they were found to have kept inaccurate books and records of their own - for more than just the Dollar General transaction. According to the administrative proceeding, "in the United States, and at least 23 other countries, IBM made at least $200 million in revenue recognition errors in its fiscal year 2000, and at least $377 million in revenue recognition errors in its fiscal year 2001. At least $281 million of this revenue involved the use of side letters, a substantial portion of which were side letters in which IBM granted rights of return." Pretty unnerving stuff. Many of the errors related to recognition between quarters and were corrected before the SEC investigation of the Dollar General deals. No real punishment meted out to IBM for this, just the usual "cease-and-desist" action.

    Community and resort builder Bluegreen filed a non-reliance 8-K last week on its 2006 10-K and first quarter 2007 10-Q. Reason? It needs to rework its cash flow statements.

    The company had accounted for "borrowings collateralized by notes receivable as operating activities in the Consolidated Statements of Cash Flows because the majority of Bluegreen Resorts' sales result in the origination of notes receivable from its customers and accelerating the conversion of such notes receivable into cash on a regular basis, either through the pledge or sale of our notes receivable, is an integral function of our operations." That sounds like a pretty good rationale - especially because the activity is "an integral function of our operations."

    The company notes, however, that such treatment is not provided for in either Statement 95 or Statement 140. So, they're taking those activities and putting them into the financing section of the cash flow statements. While it doesn't change cash in total, cash from operating activities will be 75% higher for 2004; 72% higher for 2005; turn positive for 2006; and the negative cash flow in the first three months of 2007 will be 10% lower. The offset, of course, is higher amounts reported for cash used by financing activities.

    It seems like opportune timing: after all, when cash from operations was a positive figure, nobody questioned the fact that these activities were "an integral function of operations." Now that the cash from operations has changed color from black to red, there's a change in policy. It's not inconsistent, however, with other cash flow statement reclassifications prompted by the SEC. A while ago, there were similar reclassifications in the auto dealer industry, where floor plan financing activities were moved out of the operating section and put into financing activity. See these posts on Group 1 Automotive, AutoNation, and Asbury Automotive Group.

    A press release from the SEC yesterday highlighted their new investor "software tool" for identifying companies doing business in countries that the State Department has identified as sponsors of terrorism.

    From the press release:

    "...Chairman Cox said, “No investor should ever have to wonder whether his or her investments or retirement savings are indirectly subsidizing a terrorist haven or genocidal state. The law already requires companies to report on any material activities in a country the Secretary of State has formally designated a State Sponsor of Terrorism. Our role is to make that information readily accessible to the investing public. Making it easier to find significant information such as this by tapping the power of technology is central to the SEC's mission.” They've succeeded, and quite well I think. A quick spin around the site showed a lot of companies I'd never imagined doing business in countries that I'd never wish they would. It's all information extracted from 10-K filings. Did the SEC build the "software tool" (they should have come up with a better name - maybe "terror trawler") from XBRL technology? The release didn't mention it, but it would have been a dandy showcase opportunity.

    It's not often that firms with a market cap of less than $2 million get mentioned in this space. Today's an exception: a little outfit from Las Vegas called Power Technology who's in the business of inventing the better battery. Don't roll your eyes at the headline above and think "Ah, another tired rant about derivative shortcut testing gone wrong!" No, you can roll your eyes and think, "Here he goes on a fair value jag!"

    For that's what is interesting about the restatement that Power Technology must make. The company has issued some convertible debt containing embedded derivatives that are required to be accounted for separately from the host debt contract under the contortions required by Statement 133. Once they're separated, the derivatives are required to be presented at fair value in the balance sheet, with changes in fair value reflected in earnings.

    Now, if the company has a market cap less than $2 million, you can be pretty sure there is even less of a market demand for such derivatives in the convertible debt. So to capture the fair value of the derivative liabilities, the firm has had to call in a valuation specialist to estimate their worth. And that reflects a common view of many accounting observers: as financial reporting moves into more of a fair value world, the role of valuation specialists will expand. And auditors will have to understand what they're doing if they hope to issue clean opinions with no boomerangs.

    In this instance, however, the valuation specialist had some problems. From the nonreliance 8-K:

    We concluded that it was necessary to restate our financial results for the fiscal year ended January 31, 2007 and the financial results for the interim quarters ending July 31, 2006 and October 31, 2006 because they contained errors in the derivative liabilities as calculated by a third party specialist... After further review, we have determined that the formulas in the valuation model used by the independent valuation expert to determine the estimated value of derivative liabilities were incorrect and thus understated the value of the derivative liabilities. As a result, we have obtained a revised valuation report and have decreased the derivative liabilities to $2,013,943 as of July 31, 2006, and increased to $988,560 as of October 31, 2006, and to $1,733,570 at January 31, 2007. [Emphasis added.] Moral of the story: even if there's only one derivative security in your balance sheet, and even if you think that you're safe because you've hired a valuation specialist to "take care of things," you've still got to have an understanding of fair value concepts when you're reporting financial results. And if you're an auditor, you can't rely solely on the specialist, either. Fair value reporting will require new skills to be mastered by all, and responsibility never outsources well. (Or, just don't deal with securities that require such skills to be mastered.)

    The PCAOB released its report on the 2006 inspection of Deloitte & Touche. You can find the report here.

    Face it: we're not in 2000 any more. Firms aren't self-immolating the way they used to, and auditors - we think - are doing real audits. So, you would hope to find less outrageous findings from the PCAOB inspectors than in the past. Nevertheless, there's one interesting point in the Deloitte inspection report - and it's not about Deloitte, directly.

    The PCAOB has lately been concerned about fair value reporting and more specifically, how auditors should be auditing fair values appearing in financial statements. (Also see this story by Sarah Johnson in CFO.com.) The PCAOB's concern over fair value auditing is apparent in the Deloitte report; quite a few of their comments showed that their inspection efforts were aimed at making sure the auditors were paying attention to fair values:

  • In one audit, "the issuer incorrectly determined the fair value of warrants issued to purchase common stock because it used a block sale discount in doing so. The Firm should have identified and addressed this departure from GAAP before issuing its audit report."

  • In another audit, Deloitte hadn't completely verified the client's assertions about fair value in a goodwill impairment test.

  • In another fair value episode, the Deloitte staff had tested (for impairment reporting) the fair value of trademarks as a group rather than individually as called for by Statement No. 142.

  • On another audit, the team involved didn't test the fair value of an allocation of purchase price to the fair value of an acquired intangible asset.

  • Similarly, on another engagement, a valuation specialist had been employed to assign fair values to intangible assets acquired by the audit client in a significant acquisition - but there was no evidence of testing of the specialist's assumptions by the auditors. It seems that the PCAOB is being proactive rather than reactive. Instead of waiting for an accident to happen, it's pushing auditors to focus on fair values in their auditing process - and in turn that might make auditing firms invest more in the education of their staff in this area. If that's what the PCAOB is trying to accomplish, applaud loudly - it's the purchase of an ounce of prevention, versus pounds of regulatory cure. Wisdom at last.

  • Old news now, but worth noting: at Wednesday's open meeting of the SEC, the Commission approved a proposal to let companies reporting under International Financial Reporting Standards do away with their annual reconciliations as mentioned last Friday.

    Question: if the two sets of standards were already in synchronization, there'd be no need for a reconciliation, right? We're not there yet. So between the two bodies of accounting literature, we might get something like "convergence by decree" when this is done. And you have to wonder where that could leave the efforts to truly meld the two systems.

    Oddly enough, no mention of the decision on the SEC's website. No press release, no mention in the daily SEC Digest. Hopefully the proposing release will arrive soon; I will surely link to it when it arrives.

    This item brought to you through the FEI Financial Reporting Blog.

    SEC Chairman Chris Cox is on the receiving end of a letter sent by House Financial Services Committee Chairman Barney Frank and nine other members of Congress. The letter posits the questions: "Does FAS 140 clearly address whether a loan held in a trust can be modified when default is reasonably foreseeable or only once a delinquency or default has already occurred? If not, can it be clarified in a way that benefits both borrowers and investors?"

    Background: Statement 140 sets the conditions for when assets transferred from a firm's balance sheet constitute a sale - such as when mortgage loans are transferred from a lender's balance sheet to a qualified special purpose entity - a kind of trust - for the purpose of securitizing the loans. Once a transfer has taken place and accounted for as a sale, the originator of the assets has no further involvement with the assets put into the trust - otherwise, it contradicts the assertion that an asset has been sold. Tinkering with the assets in the trust after its creation could negate the sale and result in its reversal. So, with subprime loans dissolving all over the country, banks that originated the loans and transferred them into securitizations might be hesitant to change loan terms. To do so might indicate a continuing involvement, and make the assertion of a sale contestable. They might find that they have to restate past financials where a gain on sale was recognized and treat the securitization as a borrowing instead - which would be a negative for their balance sheet. They might also be willing to go ahead and change the terms, and add more assets of their own, and toss to the wind any concerns about the accounting treatment. That could be the case if they are concerned about keeping intact their access to this kind of financing. What Representative Frank and his co-signors seem to be suggesting: does it say in 140 that you'll ruin the sale treatment if a firm modifies terms of assets in a trust when you figure that they're going to fail without some negotiation? It doesn't explicitly say that, but it's implied. Because it's implied only, it sounds like the Congressmen want Chairman Cox to get the FASB to issue some kind of exemption so that lenders might be willing to postpone the inevitable from their deadbeat subprime borrowers without risking accounting consequences. In other words, can we have our cake and eat it, too? Sounds a lot like what happened with regulatory capital in the late '80's savings and loan debacle.