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"Lucky Strikes" II

Oct 31

Written by: Jack Ciesielski
10/31/2006 8:40 AM

Now that my coot attack has subsided, let me tell you about one of the more interesting exchanges during the conference. It encapsulated a lot of the "who's at fault discussions" going on. And it brought out an interesting angle on auditing that perhaps should be pursued by the Big Four auditors.

Moderator Katherine Schipper asked PCAOB board member Daniel Goelzer if the PCAOB will take auditors to task in their reviews of registered auditing firms, for not noticing backdated options in the first place. Goelzer's answer: there are understandable reasons for missing the misdating. Most of these firms were using APB Opinion No. 25 accounting for their option plans with a resulting compensation balance of zero being reported. Why would they spend much time and effort auditing such an amount if they didn't suspect malfeasance in the first place?

(Not discussed: during the periods in question in the backdating scandals, the auditing business was a much different animal than it is now. Post-Sarb-Ox, there's a lot more focus on documentation, and no "cross-selling" efforts between auditors and the consulting side. Pre-Sarb-Ox, it was a lot wilder and woolier. When we look at the issue now, I'm not always sure observers remember that today's auditors are much more sober bunch than what existed in the heyday of backdating.)

Ms. Schipper then asked if the auditors should have caught the misdating of their audits of footnoted Statement 123 information. Theoretically, auditing that footnote information vigorously could have uncovered contracts with incorrect dates - and this has been a fixture of financial statements since 1996. The whole thing could have been avoided. Goelzer's reply was that an audit is an document-driven process, and most auditors might have had no reason to believe that the documents they were examining were false at the time. Another member of the panel, Peter Klinger of BDO Seidman, chimed in that auditors don't usually devote the same amount of attention to footnotes as they do to financial statement amounts. (I think Goelzer agreed with him.) That's not a comforting thought to investors who often rely on the footnotes as much, if not more than, the actual financial statement amounts.

Professor David Larcker, one of the conference organizers, reminded the panelists that there was a body of academic literature existing as far back as 1997 showing that opportunistic pricing of options had been found. (Surprise: Erik Lie was not the first academic to discover it. Take a look at "Good Timing: CEO Stock Option Awards and Company News Announcements" in the Journal of Finance, Vol. 50 No. 2, June 1997. Available on the SSRN Network.) Why didn't the auditing profession take note and sharpen their focus on option awards?

Good question, and no really clear answer emerged from the discussion. My own interpretation: we're looking at things with perfect hindsight, and everything looks so obvious when you look at the past. For instance, some of the graphs shown at the conference were amazing: it was a plot of cumulative stock returns before and after the grant date of options for a sample of 7,786 grants from 1,970 companies from 1996-2005. Wish I could show you the graph here, but let me just say that it looked a lot like a "V": the returns sloped down just before the award date, then sharply curved upward. That's not a small sample either: the sample covered approximately 89% of the U.S. market capitalization. Shouldn't it be obvious to auditors?

Well - no. We're looking at the forest now, with perfect hindsight. And auditors, if they were looking at all in the late 1990's were looking at trees, and probably not too closely. You almost have to ask why everyone didn't notice - investors and regulators included.

That's not an excuse for auditors: Larcker's point is a good one. Maybe auditing firms do look at the academic literature for an auditing advantage already - but if they do, they seem to have missed a pretty good way to have sharpened up their auditing processes. After all, as the investigations now show, the SEC uses academic literature for scoping things out. (Lesser-known example: Professor Carol Marquardt of Baruch College brought regulatory attention to EPS management through her work on the infamous "CoCo" bonds.) Maybe the Big Four's national office think tanks will recruit more heavily from the ranks of academe in the future.

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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.

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