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The Cost Of Backdating

Sep 28

Written by: Jack Ciesielski
9/28/2006 3:35 AM

A study done by Bloomberg News on the price effects of backdating probes shows that the investigations have "cost investors $7.9 billion in market value." The article goes on to state the underperformance of the companies compared to their peers and/or the S&P 500 index. Maybe that shouldn't surprise anyone by this time; late in the article, there's an admission that "the market has a tendency to overshoot on fear." At least when you're talking about Apple, which has gone up 37% since dropping by 6% on the day its backdating probe was announced.

The article talks about the market costs of the options probes - but those change from day to day, and the memory of Wall Street is a funny thing. For instance, the article also notes that the impact on stocks at the time of the announcement has diminished: it's dropped in more recent announcements. The article mentions that the "average one-day loss for the first 30 companies to disclose investigations, from March 14 to May 25, was 2.9 percent, or 2.8 percentage points worse than their peers. The last 30 disclosures as of Aug. 31 prompted an average decline of 1 percent, trailing peers by 1.2 percentage points."

Chalk up market effects to evidence about poor controls, poor corporate governance, expected management distractions, or any combination of the above. Market effects might also include anticipated cash costs - but those are so fuzzy to predict, it's hard to believe they'd be currently well-incorporated into stock prices. And they're likely to be "sticky:" they're not likely to be incurred all at once. But incurred they shall be, and the markets might find more to dislike as they're more visibly quantified.

Some possible cash costs that the markets might not yet have fully digested (because they're still pretty much unknown):

Taxes. Finding out that options may not have been validly issued could negate past cash savings on income taxes. Filing amended past tax returns with evaporating deductions could lead to big cash payments - and it's nigh well impossible to guess how much from published financial statements.

Auditing costs. It's not clear how far back misstated financials will have to be restated, but for now, it's reasonable to expect that all material misstatements will be restated. The Commission has effectively warned companies to be very careful about making assumptions about how far back they need to go in restating, in this letter from Chief Accountant Conrad Hewitt issued last week:

"...The staff understands that errors related to the issues addressed in this letter may affect several years of filings, and that companies may believe that amending all of the affected filings is unnecessary. Companies that propose to correct material errors without amending all previously filed reports should contact the staff of the Division of Corporation Finance. No amendment of previously filed reports is necessary to correct prior financial statements for immaterial errors."

If it isn't immaterial, don't expect not to restate... get it? That's the message, it seems.

When the market gets hold of increases in audit fees for the examinations, there's bound to be the cost-versus-benefit kinds of stories in the media, apart from the "shareholder pocketbook" stories like this one. It'll be easy to put down the cost of the auditors: after all, they're part of the cost of restating financials that today's investors might rarely read. Maybe, maybe not. If a management team is still in place at a firm where the company engaged in option skullduggery ten years ago, that would seem to be information that a current investor would still be interested in knowing. Even if there's a complete turnover in the executive suite, today's investors would probably be interested in knowing about the extent of past transgressions: corporate cultures don't necessarily change in the space of ten years.

When it comes to restatements going back longer than just a few years, this is pretty much uncharted territory - it just hasn't been prevalent, at least to my memory. To get today's figures cleaned up, it might be necessary to dive into financials of ten years ago. The options problems being investigated involve plenty of specific documents that may no longer exist, and contacts with people who may have departed the companies - or even this world - long ago. Yet the current financials could still carry an impact from the proper accounting being applied ten years ago - and it isn't going to be cheap or easy to find out what that impact is. Do shareholders deserve to know? Yes. Should they complain about the cost? No. If something unfavorable to shareholders has occurred in a company in which they invest, they'd be foolish not to want to know. That's what the audit function is supposed to provide the shareholders, so they shouldn't have a problem with audit fee increases due to this activity. (If there's a problem with audit fees at all, it should be that they didn't reflect this kind of work ten years ago.)

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Pension & Other Benefit Plans: A Look Ahead

Investors in firms with defined benefit pension plans always face the risk of suddenly being pushed farther back in line when it comes to being served their returns. Variability in plan assets and variability in benefit plan obligations are the reason: poor asset returns coupled with sinking interest rates always spell tough times for defined benefit plan funding. In that regard, this year’s asset returns combined with the Fed’s “Operation Twist” add up to “Operation Agony” for defined benefit pension plans. If trends continue along their current path, firms that may have anticipated moving to more realistic pension accounting - like Honeywell, AT&T and Verizon already have done - might forego that decision. It could be just too painful.

Pensions aren’t the only kind of benefit plan affected by Operation Twist. Other postemployment benefit (OPEB) plans share much the same accounting model as pensions, including the calculation of a projected benefit obligation that similarly incorporates a discount rate - one that will also be affected by Operation Twist. The net OPEB obligations were slightly less than pension obligations at the end of 2010, but also promise to grow in 2011. Investors perceive them as less threatening than pension obligations because they don’t require funding. Strangely, there are a number of firms that are recognizing income from these benefit plans - without ever creating a dime of cash for investors.

A recent edition of The Analyst’s Accounting Observer dissects these issues, and is available only to paid subscribers. A condensed version is available for free upon request. To receive it, send an e-mail to Brenda Rappold at brappold@accountingobserver.com, with “PENSIONS” in the subject line.

For information about subscribing to The Analyst’s Accounting Observer, click here.