"Sweeping" is perhaps the best word that describes the changes in acquisition accounting coming up in a few short months. Around the turn of the century, the original Statement 141, "Business Combinations," tossed out the opaque pooling-of-interests accounting choice for merger accounting. In tandem with Statement 142, "Goodwill and Other Intangible Assets," which ended the amortization of goodwill, the last revision of acquisition accounting seemed revolutionary.

As far-reaching as those changes were, there was plenty of room for improvement in accounting for acquisitions. Four years after the 2001 standards went into effect, the FASB and the IASB jointly considered revising their respective business combination standards. The completed FASB standard, Statement 141(R), goes into effect in years beginning after December 15, 2008. Naturally, it will only affect those firms making acquisitions - so there won’t be any broad-based effects to notice immediately. Over time, however, practically all companies acquire others - and the increased transparency created by Statement 141(R) around deals will show much more about the economics of deal-making and the after-effects. The overarching theme of the new standard: more fair value reporting, at the time of an acquisition and in reporting afterwards.

2007 Stock Option Database (Excel Spreadsheet)

It’s not the addiction it used to be. Issuing stock options as a way of rewarding employees is not as prevalent as it once was, and restricted stock compensation has moved to the forefront. When stock option issuance was at its most popular, financial reporting was seriously incomplete because the faulty accounting for stock options did not show investors all the costs of production - and at the companies where options usage was heaviest, costs were the most understated.

The required application of Statement 123(R) in 2006 changed that: it put options on the same level accounting playing field as cash and restricted stock awards. No more "stealth compensation." While many pundits expected investors to be turned off by sudden recognition of stock option compensation, the S&P index advanced almost 14% in 2006 - and the earnings of the S&P increased over 21%, despite new recognized costs. The sky didn’t fall in 2006.

The sky did fall in 2007 - but it wasn’t because of stock option accounting. Though companies now have to account for all manner of compensation, they still don’t always seem to take shareholders into consideration. This report examines trends in stock compensation for both restricted stock and options in the S&P 500.

Credit derivatives have certainly made life interesting in the last year. Perhaps the most common credit derivative is the credit default swap. They’re over-the-counter derivatives that are essentially a bet on the creditworthiness of another party. They’re not very different from an insurance relationship: one party guarantees the performance of another, for a fee.

Where credit default swaps become problematic for the entire economy: how creditworthy are the firms making the bets - the counterparties? There isn’t much public reporting of the prices of the swaps themselves, and no central clearinghouse for trades. Credit derivatives are often employed or written by non-public players like hedge funds or sovereign entities, so there isn’t much visibility into their activities. Even at the level of publicly-traded companies taking on financial responsibilities tied to these instruments, there’s an informational drought. That’s patently unfair to investors: while they might be satisfied with the liquidity and cash-generating ability of a firm in which they’ve invested, they could still be blindsided by said firm’s obligation to pay for an entirely different firm’s failure to meet its obligations. Without disclosure of such obligations, an investor would never know about such potential.

The least heavy-handed kind of regulation may be on the way: sunshine, the best disinfectant. The FASB has proposed a welter of disclosures to be effective in financial statements beginning in fiscal years ending after November 15, 2008. If the proposal goes through as planned, there could be a lot of panicky dispatching of credit derivatives in the second half of 2008 by players afraid of showing too much exposure.

Opinions vary as to the current state of the credit crisis: we’re near the end or we’re somewhere in the middle, depending on whose data you believe. Regardless of the progress made, one fact is clear: when the credit party was in full swing, it was hard for regulators to monitor all the bad loans made. That’s because they were cleared off lenders’ balance sheets as soon as they were made through the alchemy of securitization, where illiquid assets like mortgages and receivables are packaged into bond-like securities. Once those securities are dispersed through the financial system, it’s hard to tell where the damage resides. The underlying mortgages go sour, and so do the securities that may have traded many positions away from the initial securitization.

The accounting for securitizations is either simple or overly complex. If firms treat securitization transactions as secured borrowings, the accounting is simple. Should firms treat securitizations as a sale of assets, the accounting is tortured to make it fit into the concept of a sale. The sale treatment may have contributed to the current financial distress: if securitizations accounted for as sales had been more accurately accounted for as financings, balance sheet leverage might have limited securitizations of the more treacherous assets.

As so often happens with accounting standard-setting, it’s time to fix the barn door: the horse is three counties away. In January, the SEC acted schizophrenically on securitization accounting. On one hand, it promoted the continuance of the tangled accounting model in Statement 140 by giving a bye to lenders who renegotiate mortgage loans already sold in securitization transactions; on the other hand, it instructed the FASB to fix the underlying principles in Statement 140 that have caused issues. The FASB is close to issuing possible changes to Statement 140 that, if enacted, would cut the number of new securitizations earning sale treatment - but the fix is not going to be pretty or popular with either preparers or auditors. Without widespread acceptance, it’ll be hard for FASB to get the fix in place by year end.

2007 Pension Database for S&P 500 (Excel Spreadsheet)

2007 OPEB Database for S&P 500 (Excel Spreadsheet)

Just two short years ago, the chief accountant of the SEC laid out a "road map to convergence" for the melding of United States FASB accounting standards with the International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board. Don Nicolaisen’s road map ultimately called for the elimination of the IFRS-to-GAAP reconciliation in SEC filings by the year 2009 or sooner. "Sooner" is looking like "now:" in July, the Commission issued a proposal for the reconciliation’s current elimination. In August, the Commission issued a Concept Release to test the merits of allowing U.S. registrants to choose between FASB standards and IASB standards in preparing their financial statements - a more extensive proposal that could eventually put all accounting standards under one roof, but create surprising costs and inefficiencies along the way.

Should these two proposals become reality, the main benefit to shareholders would be an increase in investment choices on the United States exchanges: conversion to United States-style reporting, a long-standing barrier to foreign filers, would be removed. The exchanges would likely be flooded with new registrants. The question: are more choices always worth the cost? This report presents the highlights of the two proposals. It also compares 129 IFRS-to-GAAP reconciliations by foreign registrants to see if the two reporting systems currently produce similar results. The short answer: there are still plenty of major differences between them.

Pension plans were at the forefront of investor attention a few years ago: the confluence of low interest rates and a multi-year bear market inflated unfunded obligations for defined benefit pension plans. The prospect of federally required contributions to those plans focused investors’ minds on them; they didn’t pay nearly as much attention to other postemployment benefit (OPEB) plans, where there’s no similar governmental push on funding. Nevertheless, the same outside forces - bear market, low interest rates - swelled unfunded OPEB obligations.

Last year, a new accounting standard (Statement 158) plopped the funded status of both kinds of benefit plans onto a sponsoring firm’s balance sheet, without changing any of the other accounting for benefits. Statement 158 couldn’t have arrived at a better time to go unnoticed: pension plans came close to the edge of being fully funded for the first time in years. In the S&P 500, the median funding ratio (assets to plan obligations) was over 94% for pension plans, the ones that can bite investors hardest. OPEB plans weren’t nearly as well-funded, but they also improved markedly. It’s too early to tell what 2008 will bring, but if the early turmoil is any indication, Statement 158’s "on-balance sheet" reporting of benefit plans might draw a lot more attention than last year. Should benefit plan funding take a giant step backwards, at least it will be a retreat from a strong position. This report shows which S&P 500 firms had the strongest and weakest benefit plans at the end of 2007.

Like a team of heart surgeons defibrillating a patient, the SEC has kick-started the moribund convergence movement between the FASB and IASB accounting standards. The first electrical jolt, administered last summer, was a proposal to eliminate the reconciliation requirement for foreign filers using full IFRS reporting. That proposal is now a rule: those foreign filers reporting on the IASB’s International Financial Reporting Standards (IFRS) no longer reconcile their earnings or stockholders’ equity to a U.S. equivalent under generally accepted accounting principles. The elimination of the requirement came about before the filing of 2007 financial statements for most firms, so there’s no up-to-date pool of firms making visible the differences between the two reporting systems.

The SEC’s second electrical shock, also administered last summer, contained even higher voltage: the Commission proposed that U.S. firms be allowed to choose between reporting under U.S. accounting standards and IFRS. While the SEC hasn’t issued a decision on that proposal yet, it would be hard pressed to let foreign filers report on an IFRS basis without reconciling to U.S. standards, while requiring domestic companies - who might be competing directly with those foreign filers - to report on the U.S. basis.

The underlying presumption in both SEC proposals: the two sets of standards aren’t all that different, and they produce pretty much the same results. It requires some imagination to accept that premise, however. This report analyzes the impact of the differences for 137 companies providing the reconciliation in 2006, and the differences can be wide. For 63% of the companies, the IFRS reporting basis increased earnings over the GAAP reporting; for 34% of the firms, IFRS reporting results were lower than GAAP results. The pattern held for return on equity: 64% of the firms showed higher ROE on IFRS compared to GAAP, while 33% reported lower return on equity on an IFRS basis.

While the data may seem old, it’s the most current available - and the results are still relevant because, save for business combination accounting, most differences between the two sets of standards remain at this time.

Once-a-year events have a special cachet that resonates with people. Usually the resonation has to do with getting people to do something, like shopping: end of car model year closeouts, for instance. Christmas. Valentine’s Day. President’s Day. Memorial Day. And so on.

There’s a once-a-year event facing investors soon, and it also has to do with shopping. It’s the arrival of the annual reports and 10-Ks. Armed with the information packed within those documents, investors can ask managements better, tougher questions. They’ve got more data to analyze, and they can question the assumptions that held them captive to management dodging all year long. In short, the once-a-year gift of annual reports and 10-Ks lets investors shop harder, and lets them base investment decisions on facts, not hunches.

To get the most out of the annual reports and 10-Ks, it helps to have a plan. Blindly trying to bulldoze through all umpteen pages of a 10-K and expecting "something important" to pop up and hit you in the face is pure magical thinking, at best. At the other extreme, believing there are just a few "most important disclosures" that will reveal the future is also pure magical thinking. A better strategy is to be aware of the overall environment; map out ways that it can affect the company under review; and look for information in the accounting that either supports or contradicts what you expect. Learn from the reading. Rinse, lather, repeat. Here’s a look at the new information in this year’s annual reports that can help you shape your thinking and expectations about your companies - and a few reminders about the perennial soft spots in financial reporting.

Investors and analysts wanting to know where accounting is in most need of repair - because of abuses, financial innovation, or some combination of both - would do well to review the FASB’s docket. Every year, there’s something new added simply because the information available to investors needs to be improved. Sometimes investor information needs improvement because new kinds of deals skirt rules around existing standards and disclosures; sometimes information needs improvement because the governing accounting standards were never very good in the first place.

So, if accounting is the language of business and investing, and an issue is important enough to make it to the standard-setters’ agenda, investors ought to pay attention. It means that the "language of business" needs repair, and there’s an information gap that affects investors.

Another incentive to watch the FASB agenda: when accounting standard proposals turn into accounting law, corporate behavior can change. When a new accounting standard improves the measure of a corporate asset or liability, managers behave differently. Investors should understand it themselves, to be able to evaluate managers’ actions. Investors choosing to ignore what’s hot in accounting do so at the risk of missing meanings in "the language of business."

A supplement to Volume 14, No. 3 - A User's Guide to Annual Reports, 2004.

The American Institute of Certified Public Accountants held its annual "Current SEC & PCAOB Developments Conference" in Washington, DC last week, featuring speakers from the SEC, the FASB and the PCAOB. It’s an annual "winter carnival of accountants" from all across America who meet each year to gather year-end audit intelligence from the SEC’s staff. This year, the carnival’s attendance approached 3,000.

Over the next few months, auditors will be swarming over client’s accounting records, playing their critical role in delivering the financial reporting package to investors. As in any service endeavor, time is the most precious asset: why waste time letting a client pursue an easily challenged accounting treatment if the SEC has already described its approach to handling it? Forewarned is forearmed, and this conference provides auditors and companies with plenty of forewarning. Over a three-day span, it’s chock-full of warnings and reminders that can in the literal sense, too: the conference was beamed to the West coast and London.) In planning for accounting risks they might encounter in the audit engagement, the three days spent at this conference might pay off in a big way in terms of time saved later.

It makes sense for investors to understand issues covered at this conference too. The SEC staff sees financial statements in the review process long before investors read annual reports; investor curiosity should be aroused by what the SEC sees before the financials are made ready for prime-time. SEC staff comments don’t predict accounting disasters - but their remarks serve as a reminder that some firms may either misunderstand or misapply generally accepted accounting principles. When the correction/restatement finally comes, there’s often ensuing market confusion. That’s reason enough for investors to care about what keeps the SEC busy.

In little more than a year, financial statements will bear disclosures with strange new terminology. Investors will be grappling with the meaning of things like "Level One inputs, Level Two inputs" and "Level Three inputs." What does that mean? Are they references to CFA examination results? Video game challenges? Different circles of hell? None of the above. (Although some reporting firms might conclude that they're the latter.) The answer is that they're references to a new broad-reaching accounting standard : Statement No. 157, "Fair Value Measurements." That standard will change the way many firms measure and report the fair value of assets and liabilities in their financial statements. It comes with its own warning system indicating when the reported numbers might deserve more investor skepticism: that's the message in those different "input levels." Understanding what's underneath those input level warnings is a necessary skill for investors to build before they start dealing with the warnings.

Plenty of ink has been spilled in the financial press about the coming implementation of Statement 157, "Fair Value Measurements." Most of that coverage is negative: companies have been pushing back on the standard, petitioning the FASB to delay its implementation for one more year. "Level 3" has worked its way into investment jargon, synonymous with the already-cliched "mark-to-myth" designation.

What casual observers miss: Statement 157 doesn’t appreciably expand the use of fair value measurements. What it expands, however, is the amount of disclosures surrounding fair value reporting. Without those disclosures, nobody could make clever "mark-to-myth" remarks about Level 3 assets. Another miss: fair value reporting is nothing new. In fact, before the controversial Statement 157 was issued, the FASB’s two previous statements actually expanded the use of fair value measurements - and their arrival went unheralded. That may be due to the fact that Statements 155 and 156 were elective, rather than required to be adopted by companies. Statement 159, issued after the Statement 157 demonification began, was also elective - and it’s come in for its share of criticism ever since.

This report looks at the implementation of "Statements 627" in the real world. (That’s 155 + 156 + 157 + 159.) Lessons: you don’t hear gripes about fair value reporting when firms want it. And for all the clamor about Statement 157 at the large investment banks, there’s been surprising level of adoption among the small firms.

FIN 48 Data (Excel Spreadsheet)

About four years ago, contingently convertible bonds - or "CoCos" - were enormously popular because they hardly affected the issuer’s earnings per share calculations. Bearing slim coupons, they had the added benefit of rarely increasing the EPS denominator share count - at least, until the FASB’s Emerging Issues Task Force reached a consensus that such hybrid instruments should be treated as "if-converted" for purposes of EPS calculations, regardless of any contingencies needing fulfillment. That left a less popular convertible bond, known in accounting circles as "Instrument C,"as the best bet of companies trying to raise capital without affecting earnings or share count. These convertibles are low-coupon issues, and because only a portion of the convertible feature is handled on a treasury stock basis, there’s practically no effect on earnings per share for the issuer.

Money for nothing; interest for free. "I want my Instrument C!" became the rallying cry of corporate treasurers, after "CoCo bonds" became unattractive in 2004. Yet Instrument C is also a gimmicky creation designed to fall into the cracks created by a patchwork of accounting standards relating to earnings per share and convertible securities. The Emerging Issues Task Force tried unsuccessfully to improve the accounting for Instrument Cs in early 2007; failing to do so, the FASB itself took up the effort afterwards. Their solution for improving the accounting for Instrument Cs would be easily applied by issuers - and would have the effect of increasing interest expense and lowering earnings per share, all on a retrospective basis, to boot. Expect corporate resistance to their proposal - particularly from Wall Street firms that underwrite these things.

A few years ago, pensions were foremost in the minds of most investors as the oft-cited "perfect storm" of low interest rates and miserable asset performance swelled the unfunded obligations of pension plans. Other postemployment benefit (OPEB) plans didn’t generate nearly the same level of investor concern, despite the fact that they were also negatively affected by lower interest rates. Because OPEB plans are rarely funded, there was little cause for concern from the falling stock markets - and because OPEB plans put more discretion in the hands of the employer/sponsor than pension plans, investors shrugged. If things got bad enough, managers could always take a hard line on the plans and terminate them.

Since those dark days for benefit plans, the accounting for them has changed - neatly slicing $152 billion from the stockholders’ equity of 309 S&P 500 companies, and mostly increasing their stated leverage. The new accounting - Statement 158 - did nothing to change the way a benefit plan’s funded status would be counted; it merely put that funded status on the sponsor’s balance sheet, whether overfunded or underfunded. That funded status improved again at year end 2006 - despite declining contributions to the plans. As share buybacks increased in popularity, benefit plan contributions decreased. What might give investors pause right now: many plans have significant asset allocations to alternative investments, which might be getting rocked in the current market tumult, prompting the question of renewed contribution increases later.

FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes," became effective on January 1 for calendar year end companies. It was preceded by much corporate angst: though it had been exposed for comment in mid-2005, and issued in final form in mid-2006, firms argued vigorously in December 2006 that they wouldn’t be able to implement the standard on such short notice. The FASB received 435 unsolicited letters in the couple months just before the January implementation deadline. It sounds like even more of a protest when you compare it to the 119 responses to the standard’s 2005 exposure draft.

If not for the last-minute corporate caterwauling, the effects of FIN 48 might not have been so highly anticipated. This review of 100 large S&P 500 companies shows that the actual balance sheet impact of the implementation was fairly light-handed. While disclosures about the amount of "tax reserves" improved significantly, effective tax rates were apparently not affected much by the new standard. It’s the disclosures yet to come, however, that might have the most impact, and that’s most likely why firms stonewalled at the bitter end. How could the disclosures be so significant? Simple: they’re likely to leave clearer clues for the Internal Revenue Service to follow in their quest for closing questionable tax practices.