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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.

Manor Care Toggles Its 2005 Reporting
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Posted by: Jack Ciesielski 9/28/2005 7:55 AM
As corporate America begins its sullen march towards full reporting of stock compensation beginning in January 2006, there are bound to be "Oh-my-God" revisions to prior understandings about the workings of Statement 123 Classic, and new nuances of Statement 123 (Revised). It looks like Manor Care has had one of those "Oh-my-God" moments. The firm filed a non-reliance 8-K for its first-half 2005 filings, to be restated. Here's the reason why.

Manor Care reviewed its stock compensation accounting policies in the first quarter of 2005 in contemplation of implementing Statement 123(R). In its review, the firm uncovered one of those 123(R) nuances: it added a lot more description on how to figure out the service period over which stock compensation (whether it be minted in options or restricted stock) should be amortized. Whereas previous practice was more or less tied to explicit service periods, 123(R) required amortization over a shorter implicit period, if one is present in a compensation agreement. That is the apparent nub of Manor Care's situation: they had run amortization of restricted stock awards out to the expected actual retirement date of employees - which was longer than when they were eligible to retire. So under 123(R), amortization of the restricted stock awards is to be reported over the shorter, eligible period. Manor Care dutifully recorded a pretax charge of $10.3 million ($6.6 million after tax, or 8 cents per share) to catch up the compensation expense for years 2000 through 2004; no restatement of prior years, due to immateriality.

In addition, Manor Care recorded $8.2 million ($5.2 million after tax, or 6 cents per share) of restricted stock compensation for "retirement eligible" employees in the first quarter of 2005 - and here's where the confusion begins. After the 1Q earnings release, the firm's auditors, Ernst & Young, informed Manor Care's management that the SEC staff would continue to accept the old practice of amortization all the way up to the actual retirement date, "due to widespread practice," according to the filing.

(Funny: earlier this year, the SEC didn't accept the widespread practice of incorrect lease accounting. Maybe that's because those issues were twenty years old...)


Compounding the delay of all of Statement 123(R)'s requirements, the SEC staff would require "a continuation of the old practice for awards granted prior to the adoption of FAS 123(R),"according to the filing. In other words, only grants after 123(R) becomes effective will be getting the "implicit" period treatment.

Another wrinkle: deferred tax assets of $8.6 million ($6.9 million of which was recorded in the first quarter of 2005), shouldn't have been recorded because they won't be realized because of limits on the deductions allowed for executive compensation. It's a material amount for 2005, though not for prior years.

What's the remedy? Manor Care is pulling its year-to-date quarterly filings, and reverting back to its old accounting for the amortization of restricted stock compensation (over the longer service period) and also properly stating its deferred tax assets. The impact is mostly in the first quarter: general and administrative expenses are reduced, and pretax income is increased by $17.7 million. The deferred tax asset revision increases income taxes by $8.6 million. Combined effect: net income increases by $9.1 million, and diluted EPS increases by 10 cents. The second-quarter effect is negligible, with no change in diluted EPS.

Apparently the SEC is seeing a lot of implementation faux pas and is making allowances; this one is not something they covered in Staff Accounting Bulletin No. 107, which was their Statement 123(R) "how-to"handbook. It might be helpful for them to make some form of broader statement about this sometime before they make comments on reporting issues in the AICPA's widely-scrutinized National Conference on Currrent SEC and PCAOB Developmentsforum. (Maybe a letter like the famous February 7 leasing letter to the AICPA?) As we've seen with Manor Care, companies are working on the implementation now. December will be way too late. Is it effective for investors and analysts to see companies "toggling" their 2005 reporting back and forth between old reporting and new reporting? I don't think so.

At the same time, investors and analysts will have to expect bumps on the road to 123(R) implementation and learn to deal with them. While it's not totally different from its predecessor, that Statement was probably applied without much rigor because preparers considered it "only" a footnote disclosure. Their precision limits might be a lot tighter when 123(R) information is reported in the basic financial statements.
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