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The AAO Weblog covers accounting issues and current events as they relate the practice of investment analysis.

Jun 25

Written by: Jack Ciesielski
6/25/2007 1:41 AM 

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.)