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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.

Yesterday, Compliance Week ran an article by Tammy Whitehouse based on an interview with retired Public Company Accounting Oversight Board member Kayla Gillan. (You can access the whole article at Compliance Week for free with a quick registration.) The SEC's recent internationalization tear has left many observers concerned about the SEC's priorities; see for instance, Tom Selling's piece today in his Accounting Onion. Last year, the SEC was all over the rewrite of Auditing Standard 2, because of the uproar over the internal control provisions. It might be interesting to hear what someone close to the process had to say about that particular sausage-making:

“Some people at the SEC wanted the auditors to really only look at the process that companies go through to assess [internal controls] and not actually look at the controls themselves,” she said. “That would have been in my mind not only a much narrower scope of review but potentially even a misleading opinion to investors. At one point they wanted auditors to only look at the denied controls and not whether or not they were actually operating effectively. At one point they wanted to really significantly reduce the amount of information the auditors were required to give to the audit committee on controls that were less than material weaknesses.”

In any of those three paths - look only at internal control process, look only at certain controls, or reduce information to the audit committee - you have to wonder: how does an idea like that improve confidence of the audit committee or investors that the financial statements have been pulled together properly?

The SEC was heavily involved with the development of Auditing Standard 5, the replacement for AS2. In the end, the PCAOB prevailed; while it's more flexible than AS2, the new standard keeps in place much of the original's workings. What's interesting in the interview is the amount of SEC "proactiveness" in the process; it sounds almost as if the PCAOB was at risk of being run over by the Commission. Makes you wonder about the SEC's current internationalization efforts and therelationship between the SEC and the FASB.

On Friday, the SEC released its "Financial Explorer" to the public. It's an interface tool that will let investors manipulate XBRL-published financial statements so they can produce charts quickly. You can access the Financial Explorer tool directly at this link.

I spent a little time with it; interesting displays, fairly quick response time. (For what it does, which is still pretty limited.) Is it going to be extremely useful? Not in its current state, which I recognize is simply "early." It's more than a toy, but way less than a tool. The visualizations of the data are nice, but there has to be more meat to it. The site explains that the Explorer tool is designed for the retail investor (aka John Q. Public). But does that mean all that retail investors want is quick pictures of some data, and some visual representations of changes in metrics? If that's all that the system is going to serve up, there might be a whole generation of "retail" investors that never learns about the good stuff in the footnotes or the MD&A.

The site indicates that more data is on its way to presentation, and in theory, there should be all kinds of XBRL readers available in the after-market that will make data manipulation more custom-tailored. The present state of the art does make one consider, however: what role will the Management's Discussion & Analysis play in the XBRL world? That disclosure is one of the most investor-beneficial requirements that the SEC has ever instituted - and it doesn't seem to lend itself well to "data-tagging" and table-structuring. Let's hope the SEC focuses some its imagination on the MD&A as hurtles itself into the XBRL future. Context counts as well as numbers, and that's long been what the MD&A provides investors. How does one tag that?

In the wake of the surprise laid on the market by AIG on Monday, there’s one casualty: Statement 157. And it was just an innocent bystander.

Plenty of commentary has been spewed on the unfairness of fair value reporting, with blame for perceived inequities being laid on Statement 157. Some pundits are saying that this is an example of what's wrong with statement 157 - that it's forcing companies to come up with ridiculous values that are disconnected from long-term reality. Some express concern that trying to report illiquid assets at their fair value is too subjective and arbitrary. Some argue for keeping illiquid securities reported at their cost on the balance sheet.

Back up. First of all: AIG has not adopted Statement 157 yet. Period. Those estimates of losses aren't due to some forced, new fair value reporting; they're the result of good ol' impairment recognition.

It's a basic tenet of financial reporting: when an asset isn't worth what it cost, it's written down to what it's worth. Illiquid assets like factories and buildings, when they're not being used productively, are not carried at their historical cost: their carrying value is written down to an estimate of what they're worth. Would investors prefer that they remain stated at full cost on balance sheets, even if they producing any results for shareholders? Of course not. But there isn't always a market for them - so, by the logic of those who carp about valuing illiquid securities being "fair valued," those losses should be held in suspended animation until there's a sale of the assets. In a "real" market.

Statement 157 aside: what makes valuation issues like this one unsettling is that investors know that it's a "black box" being used to value things that aren't bathed in sunlight. Who knows how a "super senior credit default swap" should be valued? How can investors be comfortable with reported values when there's "model-switching" is going on? (AIGFP's initial model didn't include the value of "structural mitigants" or the benefit of a "spread differential;" Model 2.0 included them in November; the December values won't include the benefit of the spread differential, which helped to the tune of $3.6 billion. And AIG promises to continue to develop valuation methodologies for the year end figures, so there could be yet another version of their Binomial Expansion Technique black box arriving in time for the year end figures. Not a confidence builder for investors.)

Nevertheless - would investors be better served if managers didn't have to step up and disclose values - and how they got there? Are investors better served by "trust me" statements? I don't think so. Estimates of writedowns due to impairments have always been around. Statement 157 doesn't force anyone to use a "black box" to value anything that they haven't had to value or assess for impairments before. What Statement 157 really does is provide a framework for understanding how much investors have to stomach when it comes to black-box valuations. That fair value hierarchy (Levels 1, 2 and 3, often labeled by critics in full snark as "the three levels of hell") paints a picture of the reliability of the reported fair values. It does not expand the use of Level 3 disclosures - they've been around forever. Investors just didn't know it. How does knowing where the valuation risks exist become a bad thing for investors?

It's funny: fair value reporting under Statement 157 is getting criticized widely while asset values are being written down. Wouldn't the risks be greater if asset values were being revised upwards?

As the world trudges - make that "sprints" - towards a system of international financial reporting, one becomes curious as to how all that international standard setting is going to be financed.

Here in the United States, the FASB had long funded itself by passing around the hat: it relied on contributions from corporations, auditing firms and to a much lesser degree, investors. That funding strategy didn't do much for the appearance of FASB's independence from its constituents. With the Sarbanes-Oxley Act, the FASB's funding came straight from the SEC, eliminating its dependence on well-heeled constituents. As long as the SEC acts in the interests of investors - the intended beneficiaries of financial reporting, by the way - investors would have to feel more comfortable with the SOX set-up than the previous funding mechanism. 

The IASB, torch-bearer for the international reporting movement, still has a funding model that looks a lot like what the FASB had in place, pre-SOX. Last Monday, the IASB released an update on its funding plan for 2008.

The IASB considers its funding plan to be "broad-based, compelling, open-ended and country-specific"; it needs £16 million for 2008 and it believes it has £12.5 million secured. The funding comes from 19 different countries, based on the proportions of a country's GDP to the whole pot. That funding from each individual country is not necessarily coming from investors: it's expected to come from voluntary contributions by preparer companies within the countries, and sometimes from a country's stock exchanges or  accounting standard-setter.

The US is expected to contribute a little over £2 million from 32 companies. They must be expecting to be using IFRS soon; seems a little strange to see contributions from US companies when they can't report under that system yet. At the same time, many multinationals domiciled here have to use IFRS in their foreign subsidiaries, so it's not entirely strange.

Nowhere in the plan is there an indication of funding from investor groups. Perhaps the most interesting thing is that there is also funding from the US Fed of £200,000 - and a lot from the Big 4 international accounting firms. Combined with next-tier accounting firms, they'll contribute about £4.3 million in 2008 - about 27% of the expected budget, and 34% of the funds raised to date. It sure looks like the old FASB model of funding - and a sure-fire recipe for agitation by countries whose constituents might not like standards the IASB develops. And if you think the IASB standards are "principles-based" right now, with this much auditor involvement in IASB operations, there's the opportunity for international standards to become more minutiae-oriented down the road when auditing firms would like to have something in black-and-white for dealing with stubborn clients. Hopefully, the IASB has longer-range plans for funding independence.

The Sarbanes-Oxley Act requires that all filers be reviewed at least every three years. Over the last couple years, the SEC's Division of Corporation Finance studied the filings of more than 100 foreign private issuers. Those studies resulted in comment letters on the filings, and they're available in fairly raw form at the SEC's website. They were just waiting for someone to come along and stratify them so that some conclusions could be drawn about a) the state of foreign private issuer filings, relative to GAAP or IFRS application and b) how the SEC handled the reviews.

Fortunately, someone did come along: Deloitte. They've put together a report that's available for the right price (free) which puts together some interesting observations. From their summary:

"In the comment letters we reviewed, we noted several overall themes:

  • Focus was more on the primary IFRS financial statements than on the U.S. GAAP reconciliation.
  • Presentation and disclosure were significant areas of focus across industries.
  • Recognition and measurement comments varied by industry.
  • There was a particular interest in “converged” standards.
  • Comments were geared toward understanding the judgments made and assumptions used in applying IFRSs."

That first observation is interesting - and it meshes well with the SEC's mention (in the proposing release for the IFRS/GAAP reconciliation elimination) that its first practical experience with IFRS came with its review of the FPI filings. And the fact that the focuse was more on primary IFRS financials than on the GAAP reconciliation hints at where the SEC's mind has been for the last couple of years.

On average, there were 19 comments for each filer.

The report also mentions that "certain" comments were issued on a forward-looking basis - meaning, comments were made to the effect that "something wasn't disclosed completely, but you can do it right next year." The report also mentions that a few comments required restatement.  It makes sense that the SEC wouldn't drill companies too hard - as enthusiastic as they've been about  encouraging the spread of IFRS, it wouldn't be too  wise to make it look like adoption would require restatements or a lot of head-butting with the SEC staff. Look at the corporate angst over something as  elemental as  internal controls. IFRS proponents don't want to experience that kind of wrath.

Call that a principles-based title. It gets the point across, but doesn't it make you just a little bit uneasy about the content of what you're about to read?

Well, that's perfectly normal for you to be uneasy perhaps, if you've been reading these posts for a while. But my point is that there's almost a mindless infatuation with "principles-based standards" going on in the big auditing firms. The simplification promised by moving to international accounting standards and all their "principled-ness" is coming down to the level expressed in that title.

Evidence: the Global Public Policy Symposium held in New York on Tuesday. At that conference, the Big 4 + 2, unveiled a joint presentation on "Principles-Based Accounting Standards." There's not a lot of really new thinking in it, but what's striking is the unanimity of the CEOs of those firms: they're all thinking in lockstep on the subject, all heartily endorsing IFRS. 

IFRS is a noble goal, as well as convergence of US standards with IFRS. But before blindly blaming every capital market problem on "rules-based" accounting standards, wouldn't it be a good idea to consider that IFRS is still pretty young at heart system - one that hasn't been road-tested with quite the same rigor as US GAAP?

And why do audit firms spend so much time trying to push for one system over another? Or why do they spend so much time on accounting principles in general? Shouldn't they work on auditing principles more than accounting principles? Just asking.

* * * * * * * * * * * * * * *

Thanks to the Financial Times and their accounting editor, Jennifer Hughes, for featuring in their "Accountancy" column our post about the time gap between earnings releases and 10-Qs. I hope many of their readers share our sentiments.

There are plenty of high expectations for international convergence of accounting standards. Promoters plug the portability of capital, and the fact that one language will make it easier for capital to cross borders. If the ultimate vision of future markets is that the elimination of barriers makes it all one big, happy market where capital is peddled night and day non-stop, one reporting language isn't a luxury - it's a necessity.

Markets will probably never become completely homogenous - but they're certain to look more like each other as time goes by. That means some markets will give up what differentiates them from others. And one of the unfortunate side effects of converging US accounting standards with international financial reporting standards is that, if done in pell-mell fashion, US investors might not enjoy some of the same rich disclosures to which they've become accustomed.

How so? Suppose for instance, the IASB and the FASB (with the help of the SEC) decide to converge standards on a pick-and-choose, "best of breed" basis over the next five years. Maybe the FASB standard wins; maybe the IASB standard wins. One merit sure to be a criterion: how many countries in the world already use an IASB standard that's pretty close to one used in the United States? That would tilt things in favor of the IASB standard versus the FASB standard.

For example: the benefit plan disclosures required by the IFRS standard are not as deep as what's required in the FAS 158 and 132(R) - and whenever there's stress placed on pension plans in the US, investors seem to find that there's more information they need that hasn't been supplied by the existing standards. 

Another example: there is no equivalent disclosure of "fair value hierarchy" in the IFRS standard for financial instruments. That's a disclosure that hasn't even been common yet, but you can bet in this credit/valuation environment, investors are going to keep an eagle-eye on those disclosures.

That's not the way it's planned yet. Nevertheless, as the convergence process develops, investors in the United States need to keep an eagle-eye on it - and step up to the plate if they think their interests are going to be diminished. 

After the miserable market action of the last week, it feels as though the holidays were months ago, not merely days ago. New Year's Eve will provide a lingering hangover for investors as they sort through the fourth quarter earnings reports. The sticky markets for esoteric instruments like collateralized debt obligations will make for challenging (to say the least) valuations of assets for which no readily available quotes existed on New Year's Eve. It's not even a Statement 157 world yet: that standard's effective date (recently upheld by the FASB) will be for fiscal years beginning after November 15, 2007. So the fourth quarter will not see the disclosure of fair value hierarchies for financial instruments. Starting with the March quarter however, this will be a reporting reality - one that will be of keen interest to investors, especially those investors who have holdings in the financial industry. With both sides of the balance sheets for these firms composed of mostly financial instruments, investors will want to know whether financial assets and financial liabilities are mostly Level 1, of the highest quality - or if they're mostly Level 3, the most suspect of the three levels of fair value inputs and presentation. If asset/liability presentations depend on Level 2 inputs, then investors will want to know just how Level 2 inputs were derived. Many investors view Level 2 inputs with suspicion: they wonder if logical contortions have been made to get genuine Level 3 valuations moved up a notch, out of the Level 3 dungeon. Scary - and it could happen. These are serious issues for investors. There's genuine utility to investors in the fair value hierarchy and they seem quite ready to embrace it. The big problem with the hierarchy: it isn't available to investors until the 10-Q (or 10-K, in the case of the fourth quarter) is filed. Firms aren't required to address the fair value hierarchy at the time earnings are released; there's nothing that governs the dissemination of information at earnings release time beyond Regulation. That would be a bit like regulating free speech. The only way that analysts will necessarily hear about fair value hierarchies will be when they ask about them. And there are no guarantees of a robust answer. The companies with the most to hide would be the least likely to volunteer information that would put them in an unflattering light. The time between the earnings release and the 10-Q can be considerable: a firm can be talking up (or talking down) the next quarter by the time the 10-Q is filed covering the earnings release. By the time the 10-Q is filed, the fair value hierarchy information is stale. Investment decisions have already been made. How big is the gap between earnings release and 10-Q filing? We did some digging in 10-K Wizard for the third quarter 2007 earnings releases of December year end companies and found 2,336 Item 2.02 8-Ks. We tied the dates of those "Results of Operations" 8-Ks to the filing dates of the associated 10-Qs. The table below summarizes, by sector, the gap between the time the 8-K was filed with the time the 10-Q was filed.  3Q2007: Median Days Between Filing Earnings & 10Q



Median Gap

Max Gap

Consumer Discretionary




Consumer Staples












Health Care








Information Technology


















Read More »

Last November, the SEC voted to eliminate the reconciliation that must be included in a 20-F annual report if a foreign private issuer is presenting its financial statements in accordance with International Financial Reporting Standards as published by the IASB. The official release (No. 33-8879) came to be on December 21, 2007 - with an effective date of March 4, 2008.

That gap - no pun intended - means that affected companies with years ending after November 15, 2007 but wishing to file before March 4, 2008 will still have to comply with the reconciliation as it exists today. So we may still see a few reconciliations, and still get to ponder the wideness of the GAAP in the two sets of standards in terms of recent history. It's possible though, that the SEC will work with those affected companies and possibly grant them exceptions if their differences are minor enough. Too bad investors would never get to see what might be minor differences - and what might not be minor.

In other international news, the FASB sponsored a webcast yesterday. Subject: "Towards a Global Reporting System: Where are We and Where are We Going?" Moderated by Wall Street Journal reporter Senior V-P and Controller of PepsiCo; David Reilly, the panelists included Robert Herz, Chairman of the FASB; Peter Bridgman,Greg Jonas, Managing Director of Moody’s Investors Service, and Sam Ranzilla, Partner at KPMG LLC.

You can access the archived webcast at this FASB link. I haven't listened yet, but from what I've heard, there was general agreement among the group that a fully converged system of accounting could be achieved in about five years, maybe seven. Life comes at you fast, as the commercials say.

To forgive and forget. Or something like that.

In May 2004, Lucent was hit with a $25 million penalty for improperly inflating revenue by more than $1 billion. Ten individuals were also charged with reckless and fraudulent actions; their conflicts of interests prompted them to present improper financial reporting. Their actions included post-dating of documents and side-letter arrangements with third parties. Pretty damning stuff.

Three and a half years later, the firm is nailed by the SEC once again, even though it's now part of Alcatel. This time:

"...from at least 2000 to 2003, Lucent spent over $10,000,000 for approximately 1,000 Chinese foreign officials, who were employees of Chinese state-owned or state-controlled telecommunications enterprises, to travel to the United States and elsewhere. The Commission alleges that the majority of the trips were ostensibly designed to allow the Chinese foreign officials to inspect Lucent's factories and to train the officials in using Lucent equipment. In fact, according to the complaint, during many of these trips, the officials spent little or no time in the United States visiting Lucent's facilities. Instead, they visited tourist destinations throughout the United States, such as Hawaii, Las Vegas, the Grand Canyon, Niagara Falls, Disney World, Universal Studios, and New York City... "

Having once demonstrated a lack of respect for the books-and-records and internal control provisions of federal securities laws, you might expect that the SEC would wallop Lucent for a second offense. Not so. Even though this escapade  involved "improperly recording the payments for approximately 315 trips for Chinese government officials that had a disproportionate amount of sightseeing, entertainment and leisure" - a pretty clear violation of the Foreign Corrupt Practices Act of 1977 - no individuals who arranged such trips were charged by the Commission. The penalty: a civil fine of $1.5 million, plus a fine under a non-prosecution agreement with the Department of Justice. The total bill for the second offense is only 10% of the first offense.

In other words, repeat offenders get treated better the next time they offend. A frequent offender discount, or maybe the SEC was just moved by the spirit of the season.