In late June, the IASB and the FASB announced a change in their strategy for joint accounting standards projects. The previous strategy/timeline was a virtual accounting moon shot: a series of standards revisions that would command a never-before-experienced level of cooperation and like-mindedness between the two standard-setters. The revised strategy is only slightly less demanding.

The “revenues” line holds the single biggest number in the income statement. (Except for the occasional goodwill writedown in excess of revenues.) It’s one of the most crucial financial measures investors will ponder, and it’s often the focus of management mischief: think of the accounting chicanery to which investors have been subjected in the last decade.“Round-tripping” of contracts, done to bloat them and add to investor appeal.“Buy-and-hold” transactions where early customer purchases were not really sales at all. “Principal vs. agent” transactions where transactions were reported on a gross basis for say, a ticket price, when the real revenue earned only amounted to a commission on that gross price. And those are just a few examples.

    Maybe because it’s the single most important number in the income statement - after all, nothing happens until someone sells something - or maybe because rascally revenue recognition erupts every few years, the U.S. accounting standards dealing with revenue recognition have multiplied like rabbits. The section of the U.S. accounting standards codification covering revenue recognition is composed from more than 140 pronouncements issued over the years. Some of it is very specific to certain kinds of transactions; some of it is very specific to certain industries. Oddly, none of it contains general guidance on revenue recognition for services. Revenue recognition issues have been frequent agenda items for the FASB’s Emerging Issues Task Force, indicating that the current standards are substandard, themselves: if the accounting principles were effective, they wouldn’t need such frequent interpretation. How frequently? Two of those EITF consensuses became effective within just the last month, though their genesis began several years ago.

    Since 2002, the FASB has worked with the IASB on a joint project to improve revenue recognition standards. On the FASB side, the greatest improvement would be a comprehensive set of revenue recognition principles that don’t require constant repair and maintenance. On the IASB side, the greatest improvement would be more consistent principles that could be applied in more specific situations. For example, there’s little guidance on revenue accounting for arrangements containing multiple elements. Both sides have something to gain from this project, and developing a joint standard is a meaningful standards convergence step. Here’s how the joint proposal will work, in its current form - and how it could affect current revenue recognition practices in various industries.

2009 S & P 500 Pension Plan Data 2.0 (Excel Format)

    The accounting standards governing financial instruments are a rickety stack of piecemeal fixes for problems arising at different times in the history of financial reporting. What the FASB has done with a pair of proposals covering reporting of financial instruments and other comprehensive income is novel: they’ve come up with a sweeping overhaul that’s better than what it replaces, and better than the approach taken by its standard-setting counterpart, the International Accounting Standards Board.

    The financial instruments accounting proposal is the more dramatic of the two. It eliminates thefamiliar classification of financial instruments as held-to-maturity, available-for-sale, and trading, replacing them with just two: fair value and amortized cost. Both classifications earn a place on the balance sheet, and both will affect income statement presentation. Depending on the business model of the firm using them, some financial instruments may be reported on a fair value basis with changes in fair value reflected in earnings. Some financial instruments may be reported on a fair value basis, with cost basis-figured interest income (and impairments, where necessary) reported in net income. The fair value changes for such instruments would be reflected in other comprehensive income. That’s where the second FASB proposal comes into play. To give the effects of all fair value reporting equal prominence, the proposal requires that firms present a “continuous statement” of comprehensive income. No longer can firms bury the statement of comprehensive income in a stockholders’ equity schedule. Now, comprehensive income gets its due - on the same page as net income.

    The proposals provide a smorgasbord of accounting presentations: there’s something for every appetite. Regulators can tuck into the amortized cost information in setting capital requirements; cautious investors can savor fair value basis presentations; and companies can pridefully cook up their earnings presentations on an old-fashioned, net income basis - with their favorite adjustment seasonings, to boot. The presence of more information should make investors think more critically. So far, however, there’s been little support for the proposal from any quarter. Financial institutions have roundly criticized it: their financial statements would bear the most striking changes.

Consider the modern corporation to be a collection of individual minds, intangible assets, financial capital and physical resources. Without another element of production -  management - a corporation is a mere collection of disparate production inputs that don’t do anything on their own. Management essentially breathes life into those assets: acting in the interests of shareholders, it makes those various assets produce profits for shareholders’ benefit.

    Markets for production inputs are competitive and open. Utilizing the best physical and intangible resources at the lowest price and finding the cheapest capital are basic managerial tasks in bringing returns to shareholders. Managers are paid to push hard for seeking cost-effective production inputs. Naturally, they’re not of the same cost-containment mindset when it comes to the price of their own compensation - another production input.  The market for the price of management services can hardly be termed “open.” It’s as fair as a Soviet election: annually, shareholders get to approve or disapprove a compensation plan developed by consultants and approved by the board’s compensation committee, a plan built on comparisons to the pay packages of other firms. The only thing shareholders can do is vote against a proposed  plan, but they usually don’t. Occasionally, a “say on pay” vote is allowed, but they’re non-binding and thus, toothless.

    If investors thought about the cost of managerial inputs compared to the cost of other production inputs, they might nix proposals on executive compensation plans more often. While investors will concern themselves with the effect of other  costs on profitability, they don’t usually analyze the cost of managers relative to other production inputs. In this report, relevant comparisons are demonstrated. The results show that management compensation is out of proportion compared to other costs that produce shareholder benefits.

In February, we  reported on the upcoming changes in revenue recognition for firms with multiple-deliverable arrangements (Volume 19, No. 4: “Rock ’n Roll Revenue Recognition: How Growth Will Thrive.”) A re-read is recommended, but here’s the bottom line: because of two EITF consensuses effective in years beginning after 6/15/10, certain firms will find it easier to recognize revenue linked to each component of a multiple-deliverable arrangement as it’s delivered or completed, instead of recognizing revenue gradually. Some firms are going to have revenue recognition growth spurts. Adoption methods allow a choice of retrospective or prospective treatment; don’t expect consistency among companies. Prospective adopters may report juiced revenue growth rates: they’ll recognize revenue faster than before, but compare them to previous years’ revenues that reflected slower revenue recognition. Bolder comparisons result.

Pensions have a way of making things not safe in the workplace, on a couple levels. If you’re an employee who’s hoping for a retirement someday, they’re a wonderful thing - until the day you find out that your firm is freezing them or cutting benefits to keep the whole plan going. And in the investor workplace, pensions bring a lot of performance noise into the financials that relates more to accounting prowess rather than managerial ability. Parsing them out can be workplace pain for investors.

    Overall, pensions improved greatly in 2009 in terms of funding. 2008’s scary markets directly impacted the funded status of pensions, and 2009’s rebound did wonders for defined benefit pension plans - even if they’re not out of the woods. There’s still quite a gap from them being fully funded. One thing that’s different in 2009: the new disclosures about asset classes and fair value hierarchy provide investors with more warnings about funding adequacy than ever before.    

On March 23, President Obama signed the reconciliation bill that made the Patient Protection and Affordable Care Act a working law. One part of it immediately affected corporate financial reporting: it changed the value of deferred tax assets related to a corporate Medicare subsidy. Whenever a law is enacted that changes the value of a tax asset or liability, the change in that tax asset is recognized immediately in the period of the law’s enactment. 

The elimination of tax deductibility for the retiree drug subsidy is what’s behind the hailstorm of announced first quarter deferred tax asset writedowns. In tax years beginning after December 31, 2010, employers can be reimbursed for 28% of their retiree prescription benefits costs, provided they’re supplying benefits that are the actuarial equivalent Medicare Part D benefits. Right from the start, their pretax prescription benefit cost is 72% of what it would be without the subsidy. On top of that, they get a tax deduction for the full 100% of the benefit cost - no exclusion for the subsidy. At a 35% tax rate, the tax benefit would be 35 cents for every dollar spent. After subsidy and tax benefits, an employer’s cash cost could be just 37 cents on the dollar - for just those prescription benefits. The subsidy gives rise to a deferred tax asset because the cash tax benefits are based on the full expenditure amount.

The “double-dip” sweetener in the above scenario - deducting 100 cents of the expenditure without reducing it for the subsidy - is what gets eliminated in the law in tax years beginning after December 31, 2012. Firms will no longer earn a deduction for the portion of benefits covered by the Part D subsidy - and that means deferred tax assets attributable to those deductions have to be written down.

In our Investor’s Guide to 2009 Annual Reports (Volume 19, No. 5), we familiarized investors with new accounting issues and reminded them of ways to use accounting information to add color to their views on a particular company. Here’s an additional suggestion to consider in reviewing annual (and quarterly) reports: consider Level 3 exposure as a routine matter. When the fair value hierarchy first appeared in financial reporting in 2008, investors paid plenty of attention to Level 3 assets - mostly because they were associated with floundering financial institutions that held securities classified as Level 3. Yet Level 3 asset valuations aren’t inherently wrong; it’s just that they’re inherently pliable, depending on management intentions. What’s indisputable: because they come into play when there are no values available from active markets, the assets are inherently illiquid - and anyone  concerned with a firm’s liquidity should take into account the degree to which Level 3 securities are a part of a firm’s balance sheet.

10-K season is in full swing. The deadline is already past for the large accelerated filers, and by month’s end, all stock market inhabitants should have their annual filings deposited in the SEC’s EDGAR archive.

    You might be overwhelmed by the sheer volume of reading you’ve got ahead of you. Before you start “skimming” way too much in an effort to get through the stacks, take a deep breath and pull back. Take time to figure out what’s really important. After all, the level of disclosure is not going to be higher any other time of the year. While there isn’t any single magic disclosure or ratio that will always save your investment - and your neck - one thing the annual report and 10-K offers investors is more context than usual. There’s a better chance than usual for the investor to separate the trees from the forest. The process: form expectations; look for support or contradiction; reconcile findings to expectations; repeat

Last week, the SEC released a statement supporting convergence of US Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). While it definitely showed a commitment to the convergence process, it fell well short of a vow to require US adoption of IFRS. The Commission plans to make a decision on that in 2011, a date that’s significant for two reasons. One: at the September summit in Pittsburgh, the Group of Twenty nations requested accounting bodies to achieve convergence in accounting standards by June 2011. Two: that’s exactly what the IASB and the FASB have been doing at fever pitch ever since then, putting their efforts behind joint standards on major projects with near-Olympian vigor. If the Commission is satisfied in 2011 that IFRS adoption is a good idea, they expect that it could be implemented in 2015 or 2016. Consistent with the non-committal tone of the statement, the door remained open that early adoption might be permitted in the event of national IFRS adoption.

Revenue recognition (“rev rec,” in accounting-speak) is ratcheting up and arriving earlier for some companies. Firms making their living by engaging in multiple-deliverable arrangements (contracts for a plethora of services or goods to be delivered at various times, with one price tag for all) have long hated the accounting for such deals. They’re required to parse such arrangements into identifiable pieces and recognize the revenue from each piece as it’s completed. That’s not the problem for them: it’s the accounting requirements for evidence of each piece’s selling price frequently making the disaggregation goal impossible. If disaggregation can’t be achieved, the revenue is deferred, with recognition taking place after all contract elements are delivered. Sometimes, recognition may occur ratably over the contract term.

    That retards revenue growth, making the accounting standards a target of wrath for many technology and consulting CFOs. Recently, the FASB’s Emerging Issues Task Force (EITF)greatly liberalized the requirements for objective evidence of each component’s selling price, making it much easier to achieve “componentized”revenue recognition for multiple-deliverable arrangements - and to recognize revenue faster than under the more restrictive fall-back deferral approach. The EITF also freed tangible products containing software from being accounted for under restrictive software revenue accounting methods, in many cases. The change to this new accounting was part of the reason for Apple’s recent revenue growth.

Last month, the FASB updated its Accounting Standards Codification, requiring firms to furnish incremental, enhanced disclosures about fair value measurements.  (Official title: Accounting Standards Update 2010-06. It updates the codification Subtopic 820-10, Fair Value Measurements and Disclosures, or what used to be called Statement 157, “Fair Value Measurements.” It was called other names as well.) The good news: the new disclosures will shed even more light on the nature of the valuations of financial instruments. The bad news: they won’t show up in 2009 annual reports; some key disclosures won’t arrive in 2010 annual reports.

Statement 167, Amendments to FASB Interpretation No. 46(R), was issued in June 2009, along with the related SFAS No. 166, Accounting for Transfers of Financial Assets – an Amendment of FASB Statement No. 140. Statement 167 was issued to allay  concerns that FIN 46(R) permitted firms to block consolidation of assets and liabilities related to variable interest entities through manipulation of quantitative assumptions. Statement 167 forced firms to use a more judgment-based analysis, on an ongoing basis, to determine whether they are the primary beneficiary of a variable interest entity; if so, a firm must consolidate the entity. Statement 166 sweeps securitization entities into Statement 167’s purview, causing them to be newly considered for consolidation.

Venezuela isn’t famous just for its oil exports and flamboyant leaders. It’s also been a self-contained producer of inflation, with consequent unpleasant effects on its populace. It’s also going to have unpleasant effects on the financial statements of U.S. multinational firms doing business in Venezuela. Starting in 2010, the consolidated financial statements of the parents will have to take into account the highly inflationary economy of Venezuela. That means a change in accounting methodology that will result in the recognition of remeasurement gains or losses directly in earnings. Previously, translation gains or losses were not visible in earnings: they were tucked away in stockholders’ equity. Now they’ll be more visible.

    The results of the change in accounting are not always straightforward; investors will find non-comparability exists in the years before and after the change. Further hampering intercompany comparability for investors: there are several different exchange rates that may be used in remeasuring financial statements, and any single rate is not always the right one for all companies doing business in Venezuela. Estimating changes in the reporting of foreign operations is not a “do it yourself” exercise that investors can prepare for themselves, leaving them at the mercy of the firms making disclosures about their Venezuelan exposure. There are no rigorous, paint-by-numbers disclosure requirements that ensure all relevant information will be released; investors’ best chances for receiving relevant information come from the SEC’s open-ended requirements for MD&A.

     If you want to know where funky financial reporting exists in America, consider paying a visit to the agenda of the Financial Accounting Standards Board. The charge of that particular standard setter is “to establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors, and users of financial information.” If there’s an accounting principle or standard on their agenda, then it must be an aspect of financial reporting that is somehow not getting the job done for the FASB’s constituents - perhaps due to abusive application, the innovations of cunning investment bankers, or a combination of both. Sometimes investor information needs reform because reformulated transactions find a loophole in existing standards and disclosures; sometimes standards need repair because the existing ones were flawed on the date of issuance. (The constantly revised standards on securitization accounting are one good example.)

    Accounting, the “language of business,” was severely tortured in 2009 - at least in the tongue of fair value. Both the Financial Accounting Standards Board and the International Accounting Standards Board devoted much effort to reforming fair value reporting standards - not so much because the investors of the world wanted them to fix something, but because political pressure made it impossible for the standard setters to leave fair value reporting untouched.

    Despite the preoccupation with fair value reporting standards and defending themselves from political interference, the FASB issued many new standards in 2009 - some with major significance to investors, others less so. The FASB and the IASB also ramped up their convergence ambitions during the year, and set lofty new targets to meet in 2010 and beyond. The following is a rundown of the FASB’s major accomplishments for 2009, and a look at the accounting news for the year.

    The trio of FASB’s April turbo-standards related to fair value reporting have now been adopted by all publicly-traded companies. In brief, those standards made the recognition of other-than-temporary impairments less painful to report because firms could direct parts of the charges to other comprehensive income; made it easier for firms to employ “Level 3” reporting of asset or liability valuations; and increased the frequency of supplemental fair value reporting.

    Because they deal most directly with financial instruments, those three amendments have the greatest impact on financial institutions. In this report, the magnitude of those effects are presented for the 79 firms composing S&P 500’s financial sector.  Some findings: banks saved more than a $1 billion in regulatory capital, thanks to the sweetened other-than-temporary impairment rules; the entire S&P 500’s earnings benefitted by nearly $5 billion and over 4%; and fair value disclosures showed a surprising lack of confidence in the credit markets for the insurance industry.

The American Institute of Certified Public Accountants held its annual “Current SEC & PCAOB Developments Conference” in Washington, DC last week, including speakers from the SEC, the FASB and the PCAOB. Accountants from all parts of America and the economy gather each year to grab year-end financial reporting advice from the SEC’s staff. Despite a still-shaky economy, the conference attendance was still well over 2,000. That’s a lot of accountants and auditors.

    Those auditors will soon be combing through client accounting records as gatekeepers in the whole financial reporting process. Time is always precious, but more so when there are reporting deadlines to be met. Auditors don’t want to waste their time - or their client’s time - arguing over a questionable accounting treatment if the SEC has already addressed it sometime during this conference. That’s one reason this conference is so well-attended. (It doesn’t hurt that it provides a huge dollop of required continuing professional education, either.) The conference provides three days’ worth of reminders for smart auditors who incorporate them into their audit plans.

    Why should investors care? Forewarned is forearmed. Investors would do well to understand issues covered at this conference as well because the SEC staff sees financial statements during their review process well before investors read annual reports. What curious investor wouldn’t want to know the SEC staff’s gripes with current reporting? The comments of these staff persons don’t predict accounting meltdowns in the making, but their comments should remind investors that firms don’t always apply generally accepted accounting principles correctly - unintentionally or not. If there’s a later revision to issued financial statements, that might be enough of a reason for investors to care about “what kept the SEC busy.”

There’s no shortage of emotional reactions on the subject of executive compensation. With the events of the past couple years fresh in the memories of investors and the general populace, executive paychecks and bonuses have been popular outlets for their rage. The focus of attention is usually on absolute pay levels, which seem absurdly high - especially in the financial sector. It’s hard to justify bonuses denominated in millions of dollars for executives whose minions came perilously close to blowing up the entire financial system, making themselves obvious targets for politicians currying favor with an angry electorate. Examined in absolute terms, executives will always appear overpaid: their paychecks are bound to be bigger than the ones of those doing the examining, so the envy factor will color judgment. Yet it may also be correct. The picture of compensation is seriously incomplete: proxy statements report the total compensation of only the top five officers, while the financial statements provide information about only the stock compensation provided to the entire employee population. Even within those constraints, investors can get a tighter grip on the fairness of executive compensation. Comparison of executive compensation to the kinds of investment spending that produces shareholder returns provides even more insight into pay fairness.

Stock compensation data items (options and restricted stock, granted and outstanding, assumptions, and other related items) for the S&P 500.

Like it or not, financial accounting affects the way investors do their homework in making investment decisions - and in turn, the standard setters who generate accounting rules affect financial accounting. Investors concerned about the way accounting standards and standard setters will affect their work should be on the edge of their seats this month. While this September may not be showing its characteristic market volatility, things are rocking in accounting-land.

    Investors are suffering accounting fatigue from the ongoing (un)holy war over fair value reporting, yet they’re perpetually curious about whether U.S. accounting standards will go the way of the dodo bird if International Financial Reporting Standards become the American measure. Financial instruments proposals from the IASB and the FASB will  be a topic at this week’s Pittsburgh G-20 summit, and the discussion could define the role that fair value accounting will play in future financial  reporting - and the fate of independent U.S. accounting standards.

Executive compensation is a perennial sore spot for investors. Compensation packages designed to knit together shareholder interests and those of the managers working for them were subverted over the years by substandard accounting standards that let compensation tied to option rewards go unreported.  By the time the faulty accounting was repaired in the mid-2000’s, the damage was probably irreparable: super-size compensation packages continued to be the norm in American companies. Even though there’s complete expense recognition given to pay denominated in options, and even though there’s now a compensation effect on earnings - equity instruments for pay continue to be dispensed like water from a fire hose.

    Instead of focusing simply on the compensation of a handful of executives, investors should focus on the relationship between “incentive” compensation and other forms of deferred compensation - like pensions. Investors worry about being on the hook for contributions to sinking pension funds - but fail to consider how management stock comp largesse compares to pension funding. Investors also fail to compare firm-wide stock comp largesse to factors affecting corporate returns - factors like research and development or capital expenditures. Finally, investors fail to look at how their ownership interests are crowded out by stock comp plans. These overlooked relationships are examined for the S&P 500 in this report.

Since 1976, lease accounting by lessees has been fairly consistent - which is to say, there hasn’t been much accounting for the assets used by lessees in their operations beyond the recognition of rental expense in the income statement. That’s because FASB Statement 13, “Accounting for Leases,” divided lease reporting into capital and operating leases. The capital lease treatment results in leased assets being reported on balance sheets and depreciated, along with a related lease obligation; the operating lease treatment showed no assets or liabilities on the balance sheet, but reported lease payments as rental expense. Being a “bright line” kind of standard - one whose application depended on meeting explicit criteria - Statement 13 resulted in minimal lessee recognition of leased assets and obligations.

IFRS lease accounting standard IAS 17 is less prescriptive than its U.S. counterpart, but produced similar results: a surfeit of operating leases, and a dearth of capital (or finance, in IFRS parlance) leases. In 2006, the FASB and the IASB started work on a joint project to remedy lessor and lessee accounting; to speed the process along, they decided in July 2008 to focus only on lessee accounting as a first phase. A “discussion paper” was issued in March 2009. If the provisions of the discussion paper become a final standard, balance sheets around the world will no longer be spared from showing the assets and obligations involved in producing returns - regardless of whether assets are leased or purchased.

In April, the FASB squeezed out a trio of amendments to various fair value reporting standards, in response to Congressional coercion to “do something” about the financial crisis. The Congressional threat: if you don’t do something, we’ll legislate relief from your standards.  Those three amendments - FASB Staff Positions, or FSPs for short - become effective in the second quarter. Firms were permitted to adopt them early, in certain combinations of the standards. Because one of the FSPs blunted the reported earnings effect of writedowns of impaired securities holdings, an incentive exists for firms with shaky capital to adopt early. At least 94 firms adopted the trio of standards early; 20 of them were members of the S&P 500 financial sector. Early adoption of the FSPs spared them pain: without deploying them, the S&P 500’s financial sector would have reported half as much in earnings for 2009’s first quarter.

The Obama administration is now moving its attention away from ending the economic crisis, and is focusing on ways to fund the cure - and fund the rest of the nation’s spending, too. The administration has released its fiscal year 2010 revenue proposals, and there are some bold, ambitious plans in it for changing the way multinational firms figure their U.S. taxes. One part of the plan: reduce or eliminate foreign tax benefits that corporations have long enjoyed.

It’s still early in the horse-trading game. Companies may have to live with some dire consequences to their business models that have developed over the years, but they also might get something in return: maybe a lower marginal tax rate or increased tax benefits for new hires or investment. While foreign earnings remain the tax target of choice, however, it’s wise to figure which companies are at risk of having the biggest changes in their multinational way of life - and what consequences their investors might face aside from just higher income taxes. There are plenty of clues firms give about their foreign operations, but they’re veiled and rarely cohesive. This is a great time to get familiar with them, and in this report, we show you how to find them and evaluate them.

The pressure brought to bear on FASB to “fix mark-to-market accounting in three weeks or else” - Representative Paul Kanjorski’s message during March 12 hearings - resulted in the release of twin proposed FASB Staff Positions on St. Patrick’s Day, with a comment period ending on April Fool’s Day. For investors, there’s nothing to celebrate in these proposals; for a bank, their passage will be like owning the keys to the U.S. mint. In preparer/auditor debates over impairment, these changes will give the upper hand to preparers in valuing assets and postponing impairment recognition.

If bad news is best delivered first and in the greatest detail, then this must be 10-K season. There’s bad news aplenty out there in the market, and now an up-close-and -micro version of it is landing on your desk and seeping into your e-mail box. Yes, it’s that time of year again.

    This is the twelfth Accounting Observer heads-up on what to seek in the current batch of annual reports. Easy prediction: this year’s annual reports are going to be thicker than ever. Preparers and auditors ought to be erring on the side of caution and putting out more disclosure than ever, as reporting risks are magnified by the credit crisis. The exercise for investors remains the same: you get out of it what you put into it. There’s no single magic disclosure or ratio that’s going to save you the kind of investment agony experienced in 2008 (and so far in 2009, too.) Reading the annual reports well enough to understand the risks involved might scare the dickens out of you - but it might also lead you to the right kind of investment decisions.

    Get the most out of the annual reports: have a plan. Don’t just expect“something important” to smack you in the face if you blaze through them - figure out what’s most important first, then search for it as you read the whole thing. Be aware of how the current environment affects the company; and look for information in the accounting that either supports or contradicts what you expect. Fire up a pot of coffee, and let’s get going.

In late November, the SEC released its long-anticipated “roadmap” proposal for bringing the United States financial reporting under the umbrella of International Financial Reporting Standards (IFRS) as issued by the International Accounting Standards Board. If you accept the premise that IFRS is the financial reporting road the whole world is traveling upon, then old-fashioned U.S. GAAP is the road less traveled.

Maybe Frost had it right. Investors are better off taking the road less traveled; it could make all the difference in the world to them, if this current proposal is the only alternative. That’s not because the standards embodied in the IFRS are inherently unsound. It’s simply because the proposed plan for conversion to IFRS from GAAP is an idea that is ahead of its time. When the milestones outlined in the proposal have been completely achieved, then the conversion might really benefit investors. The proposed timetable is hardly credible, however.

Billed as a single proposal, the “Roadmap document” really contains two proposals: one allowing firms to convert to IFRS early, and a second proposal describing how the transition will take place assuming all the milestones have been accomplished. Investors who don’t plan on retiring in the next five years - and there aren’t many these days - and who also plan on using financial statements should pay attention to this proposal’s implications for them.

Want to know where financial reporting is at its worst? Check the docket of the Financial Accounting Standards Board. Investors and analysts wanting a laundry list of accounting standards needing repair - due to abuse, clever investment bankers’ innovations, or a little of both - can find one in the FASB’s "to do" list. There’s something new added each quarter. Sometimes investor information needs repair because new kinds of deals "end-run" existing standards and disclosures; sometimes standards need repair because the existing ones were poor from the start.

It’s often said that accounting is the language of business and investing - and if that’s so, an issue worthy of a place on the standard-setters’ agenda, ought to be worthy of investor note. It means that the "language of business" is in trouble, with flawed information being provided to investors.

Another reason for watching the FASB agenda: accounting proposals that become actual standards often result in changed corporate behavior. Investors should understand changes to accounting standards themselves, so they can evaluate managers’ resulting actions. Investors choosing to ignore what’s hot in accounting do so at the risk of missing new meanings in "the language of business."

The American Institute of Certified Public Accountants held its annual "Current SEC & PCAOB Developments Conference" in Washington, DC last month, with speakers from the SEC, the FASB and the PCAOB. Swarms of accountants from all parts of America gather each year to capture year-end audit advice from the SEC’s staff. Even though the economy has belted accountants as well as investment bankers, the attendance was still around 2,500.

Soon, those same auditors will be poring over client’s accounting records, playing a gatekeeper role in the financial reporting process. From the auditor’s point of view: why let a client waste their time - and yours - pursuing a shaky accounting treatment if the SEC has already described its views on it during this conference? Forewarned is forearmed; that’s one reason this conference is so well-attended. The conference is three days’ worth of warnings and reminders to wake up auditors. The smart auditors take advantage of the accounting intelligence gathered by the SEC during the year, and imparted to the audience; the not-so-smart ones skipping the conference learn things the hard way by making the mistakes brought to light by the SEC’s staff. Three days spent at this conference can pay off handsomely in terms of time saved.

What’s in it for investors? They should understand issues covered at this conference as well. The SEC staff sees financial statements in the review process long before investors read annual reports; what curious investor wouldn’t want to know what the SEC has found objectionable in their reviews? While the SEC staff comments won’t predict accounting meltdowns in the making, their comments should remind investors that some firms may either misunderstand or misapply generally accepted accounting principles. When the correction or revision arrives, the ensuing market confusion can be enough of a reason for investors to care about "what keeps the SEC busy."

The full effects of the Emergency Economic Stabilization Act of 2008 won’t be known for years. No other piece of legislation has ever had such an impact on the relationship between business and government - or between capital and ownership of capital. The line between shareholders and state has become quite blurry.

It might have an impact on the way that companies report their results to shareholders, too - and it won’t take years to find out. The EESA charged the SEC with conducting a study on "market-to-market accounting standards as provided in Statement Number 157 of the Financial Accounting Standards Board, as such standards are applicable to financial institutions, including depository institutions." The singling-out of the oft-demonized "Statement Number 157" gives hope to the banking lobby seeking to overturn fair value reporting.

Will the SEC act in the interests of shareholders and avoid any "reform" of fair value reporting? Or will it cave in to the demands of bankers who couldn’t resist their primal lending and investing urges? Politics is never a sure thing - but it’s possible to take a close look at the SEC’s responsibility under the Act and see what facts they might find as they execute their duty. How they will interpret those facts - and then act upon them - is very much an open question until January 2, when the SEC report of its findings and determinations is required to be submitted to Congress.

If 2008 ended today, there would be no tears shed on Wall Street to mourn its passing. (Except for the shorts who made the right calls on financial institutions.)

2008’s effects on the financial condition of companies in 2009 are starting to be puzzled out by Wall Street, however. When 2008 finally does end, the funded status of defined benefit pension plans on that day will have ongoing effects in 2009. Unless there’s a sudden updraft in world markets, pensions will likely be seriously underfunded. That will have consequences for 2008 balance sheets - and 2009 reported earnings and cash outflows.

Precise estimates of how funding status will affect current balance sheets and future earnings and cash flows are not possible, but investors can at least develop ranges of outcomes to help them consider exposures. Offered here: reminders on pension reporting mechanics to help one better evaluate a firm’s pension prospects.

Financial tsunami, unprecedented volatility, history-making intervention - the financial press has already exhausted its supply of clichés, and we may be in just the early innings of the game. (There’s another one for you.)

No matter what happens next, analysts and investors still have to parse the financials - and they always start parsing the minute the earnings are released. The earnings call is where, for better or worse, many snap judgments get made by investors based on scanty information. What’s left unasked in the conference calls might be the nugget or two that provides a springboard for more management discussion leading to profitable insights.

Miss your chance to ask relevant questions in the earnings calls, and you might not get another chance. In a Regulation FD world, it’s not as easy to get a straight answer to a tough question; CFOs and investor relation managers fear giving information in a way that might be deemed "selective." After a quarter like this one, the third quarter earnings calls will be more crucial than usual - and you don’t want to wait for the 10-Qs to show up. They might not even contain the information you want. Offered here: 20 questions to ask (or listen for) in third quarter earnings calls which might expose risks or reveal operating nuances that help you better understand a firm’s performance or financial status.

Last month, the sweeping changes in acquisition accounting, Statement 141 (Revised), were reviewed. One aspect of the new acquisition accounting: firms will have to change the way they account for what’s long been called "minority interests" that result from the firm taking only a partial investment in another firm. Statement 141 (R) will make firms report existing minority interests at their current fair value when there’s a change in ownership stake, as in a step acquisition.

Changes in minority interest accounting didn’t stop there. Rather than lard up the acquisition standard with new accounting for minority interests, the FASB issued a separate standard for the second-level effects of acquisition accounting. Statement 160, "Noncontrolling Interests in Consolidated Financial Statements" changes many facets of these financial statement ghosts, resulting in a treatment more comparable to international financial reporting standards. While investors don’t often pay much attention to minority interest amounts, either on the balance sheet or the income statement, the new standard will make subtle changes affecting basic calculations in return on equity, leverage ratios, and profit margins.

"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.

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.

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."

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.

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.

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.

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.

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.

Issued last February, Statement 159 gave companies immediate and unprecedented flexibility in changing the way they account for a whole slew of financial instruments - from equity method investments to debt issued by the firm itself. The standard allowed quick-footed chief financial officers to take advantage of early implementation if they adopted the standard as of the beginning of the fiscal year beginning after 11/15/06, hadn't issued financial statements for the first quarter, and completed the adoption within 120 days of the beginning of the fiscal year. Very unusual implementation criteria, indeed. That first criteria - adoption allowed for fiscal years beginning in fiscal years after 11/15/07 - made it possible for the multitude of companies with November fiscal year ends to early adopt. The only companies with November fiscal year ends adopting the standard were the banking monoliths, however. A search of first quarter 10-Qs produced only sixty firms that adopted Statement 159. Out of those who chose the fair value option, some companies found good use for the standard: better balance sheet presentation, easier hedging, and simpler accounting for investments. Others managed to find the bad parts of the standard: they gamed the transition provisions in order to bury impairment charges. The ugly upshot: Statement 159 brings good and bad reporting to the investors' table, and it's up to them to figure out whether a company is using or abusing the standard. Investors need to understand Statement 159 pitfalls before its wider application in 2008.

In 2006, after more than a decade of wrangling, investors were finally treated to earnings containing the cost of all employee stock compensation issued. Those figures included the value of stock options, long invisible in the income statement due to an exception built into accounting standards. Statement 123(R) eliminated that exception. Despite all the corporate trepidation surrounding the implementation of Statement 123(R), its effects were downright tame. Investors didn't crunch the stock prices of companies with plenty of recorded option compensation; they chose to ignore it - or were led to ignore it by those same companies. Market observers worried about the effects of stock option recognition on profits for years - but after implementation of Statement 123(R), the S&P 500's earnings still advanced a healthy 17% in 2006. Even though all manner of stock compensation is fully accounted for in financial statements now, firms still employ it readily. At the same time, valuation of stock options granted also remains a constant concern for investors. This report examines trends in stock compensation - for restricted stock and options - in the S&P 500.

Last September, the Securities & Exchange Commission's Office of the Chief Accountant issued Staff Accounting Bulletin No. 108 to provide guidance to companies in considering the materiality of known errors in financial statements issued in prior years. In most walks of adult life, it's understood: you make a mistake, you 'fess up and learn from it. Sticking with a mistake only seems to compound the consequences. So - why the need for regulatory "guidance" in deciding whether or not a financial reporting error needs a correction? Simple: after cultivating an aura of invincibility and precision ("earnings came in as targeted"), companies are loathe to admit an error for fear of looking dumb to investors. Another reason: when it comes to the plaintiff's bar, managers don't want to look like a pork chop waved in front of a coyote. Taking blame for flawed financial reporting can do that. The SEC has a ground-level view of what's under the financial statements; they know that companies have harbored errors in balance sheets for years. Issuing a Staff Accounting Bulletin on error corrections gets them aired, and gives companies some cover to get their sins cleansed "because they had to do it." SAB No. 108 has been little-noticed by investors, largely because in certain circumstances it permits the correction of errors by adjusting beginning-of-year retained earnings. It's not often that investors prowl the statement of changes in stockholders' equity, so they'll miss SAB 108 adjustments unless they notice their mention in the footnotes. There are some real differences in the way large companies and small companies have handled past errors and their corrections under SAB 108. Furthermore, investors who look at return on equity as a measure of operating performance can be misled by the SAB 108 "catch-up" treatment: error corrections that decrease equity can improve return on equity, perversely making companies with flawed reporting look like they're doing a better job with shareholder interests.

Last month, the FASB issued Statement 159 - "The Fair Value Option for Financial Assets and Financial Liabilities." The statement didn't draw much attention in the financial press. After all, it's not a standard that will torch earnings with newly-recognized expenses like Statement 123R added when it required accounting for stock compensation, or shine a light on shadowy leverage in balance sheets like Statement 158's changes in benefit plan accounting. It's an option, not a requirement; unless firms choose it, life will go on as usual for investors. And if firms choose to adopt Statement 159, investors should be s not likely that there will be many early adopters of Statement 159, investors might start seeing its application in financials as early as the first quarter of 2007.

Some investors believe that accounting information should help them "see around corners" - to let them predict disasters long before they occur. That's an admirable ambition, but a bit lofty. It's more important to see a truck bearing down on you. Flattened investors ignored many trucks over the past decade. Put another, less graphic way - don't ignore the obvious. Once a year, the obvious is on display in the annual report. It's the best chance for an investor to get a grip on whatever risks might be lurking underneath the sound-bite earnings releases of the past year, embellished with slick PowerPoint presentation slides. Read them with a healthy dose of skepticism, and you might question your beliefs about a company and its managers. You have to look for the truck; you have to assume it won't stop for you . To that end, you can't just expect to review a couple of "key disclosures" to save your hide. You have to look at the whole package - and it's not just numbers. There are more "contextual" kinds of lessons to be learned from the disclosures added to the financial reporting package over the last few years. Here's a look at the new information in this year's annual reports that will generate investor buzz and some reminders about the perennial soft spots in financial reporting.

There's an old saying in accounting circles: "Accounting is the language of business and investing." It's not just self-elevating twaddle. It's true - and if you don't think so, take a look at the pile of comment letters received by the FASB and the SEC every time they propose something that hones the information within financial statements. If an issue is important enough to make the standard-setters' docket, investors should want to know about it. Additions to FASB's agenda mean there are problems in current reporting; it means that the "language of business" needs to be fixed. Another reason for investors to take an interest: as proposed accounting standards become accounting law, corporate behavior often changes. New accounting standards often provide better measurement of some corporate activity - whether they're income taxes, stock options, health care benefits or pensions, to name a few. And once an activity is measured, or measured better than before, it starts to be managed differently. Understanding new accounting standards can t want to know what companies will do to avoid speaking "the language of business" more clearly? Then ignore the activities of the FASB.

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. Each year, this conference swarms with accountants from all parts of America who want to hear first-hand from the SEC's staff about accounting issues that rouse them. This year's swarm was 2,900 strong. Auditors need to know these issues: when dealing with audit clients in the next few months, forewarned is forearmed. The same goes for dealing with the SEC, too. Why waste valuable audit field time on issues that the SEC already publicly addresses at this giant venue? The conference can provide business intelligence for the conscientious auditor: it's full of "knowledge nuggets" that can put an auditor on s often ensuing market confusion. That reason alone should interest investors in 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.

Like it or not, assumptions that are built into much of financial reporting. They're embedded in everything from accounts receivable (how much will never be collected?) to warranty expense (what will be the repair rate on cars sold?) Like it or not, firms can use assumptions to finesse earnings so they meet Wall Street expectations. And like it or not, firms are now required to report stock option compensation for the fair values of option grants - using estimates of underlying stock volatility. In the Black-Scholes model used by many firms, lowering the assumed volatility input will lower the compensation expense to hit earnings. The incentive to low-ball is high. The volatility input is not something that can be observed with great precision; it is, after all, an estimate made by management about the way the firm's stock will behave in the future. At the same time, the changes in the volatility assumption leave a trail of circumstantial evidence as to whether or not management has "grooved" the volatility input to achieve a lower option fair value and compensation expense. Like it or not, it's one more variable that analysts and investors have to consider in the full context of the financial statements. A look at the volatility inputs of the S&P 500 and Russell 2000 provides some background for determining whether or not wishful thinking is behind the input selection.

Defined benefit pension plans and other postemployment benefit (OPEB) plans inject all sorts of odd information into the operating results of companies sponsoring them. In June, we surveyed the state of employer promises for pensions and OPEBs of the S&P 500 - and looked at how balance sheets might be affected by the FASB's plans to move funding information out of the footnotes and onto corporate balance sheets. Consider that report to be a road map for navigating the balance sheet aspects of benefit plans - both present and future. This report reviews the current key assumptions underlying benefit plan reporting for the S&P 500, with a view toward the ways firms might "assume the best" to minimize the effects of the forthcoming balance sheet presentation.

Before there was option backdating, there was option vesting accelerating. It seems so 2005 now, as investors wonder what companies will be fingered next by the SEC or the US Office of the Attorney General - and for the most part, it is 2005's option compensation accounting issue. It lingered into 2006 because firms had until their fiscal year beginning after 6/15/2005 to put Statement 123(R) into effect. That awkward effective date made it possible for companies with fiscal years ending through May 2006 to "accelerate the vesting" of outstanding options and avoid recognizing the value of those options as compensation expense in earnings reported after 6/15/2005. The accelerated vesting gambit started in the summer of 2004, and it's now run its course: any firm that accelerates the vesting of employee stock options now will have to recognize the effect in earnings instead of easing it past investors through the footnotes. Vesting acceleration gave firms that ability to hide compensation expense a little longer. Investors may regard backdating as the more serious of the two option accounting transgressions but so far there are precious few details known about the extent and severity of backdating issues. Investors may tend to dismiss the acceleration of options as a non-event, yet the acceleration of options caused massive under-reporting of compensation expense. Worse: while companies may have defended their acceleration actions on the grounds that they related to only "out-of-the-money" options, some of those options have now come "into-the-money." Over $400 million of intrinsic value is now realizable by employees of just 49 firms that accelerated their "out-of-the-money" options over the last several years. No waiting, and no backdating - accelerating the vesting made it money for nothing. Speaking of backdating: some companies now in the news for backdating were accelerators as well.

"The road to hell is paved with good intentions." When it comes to stock options, truer words were never spoken - if indeed, options were ever issued with good intentions. Option plans have usually been cloaked in the guise of "alignment of management interests with shareholders." In view of the past spring's events, those appeals now appear more contrived than ever. And maybe not. In this post-Enron, post-SarbOx world, it's easy to look back at these transactions as one more example of unbridled executive greed. Some of them will be found to be just that - but it's also possible that some of these deals will be found to be less than completely malevolent. It would be surprising if every company that's being investigated or rumored to be a focus of an investigation was as guilty as they appear at the outset. Sloppy record-keeping and lack of attention to details may also play a significant role in backdating capers. The following is a look at the state of the investigations, the accounting issues surrounding backdating, and some venturing as to the endgame of the investigations

Mae West said it: "Too much of a good thing can be wonderful." That depends on your point of view. The employees receiving pension and health care benefits over the last fifty years or so would certainly agree with Mae. The employers paying them - and having to account more clearly for the amounts they promised, starting at the end of this year - would disagree with her. For them, too much of a good thing is awful. The following is a look at the state of employer promises for pensions and other postemployment benefits (OPEBs) in the S&P 500 - and also a look at how balance sheets will change if the FASB goes through with its proposal to move funding information out of the footnotes and onto corporate balance sheets

Corporate America's love affair with stock options has been winding down for years. In 2005, the passion dropped another few notches: for the S&P 500, option grants dropped 17% from 2004 levels. Fewer options were granted in 2005 than in 1995. At the same time, restricted stock continued to look like the new flame: restricted stock grants increased 22% compared to 2004 levels. Earnings misrepresentation due to suppressed reporting of stock compensation was 4% in 2005; it was 5% in 2004. One troubling trend: now facing full reporting of stock option compensation, many firms employing options are employing valuation assumptions that conveniently lower the estimated fair values of option grants - and consequently, lower their future expense. This is particularly unsettling after the wave of accelerated vestings of options observed in the past year.

In January, the FASB issued an exposure draft of a standard that could radically change the way financial statements look. By allowing firms the choice of reporting certain financial assets and liabilities at their fair values instead of their historical cost, financial statements might say more about the true state of corporate rights and responsibilities than they currently do. The downside: because it's a choice and not a mandate, firms won't be comparable to each other unless all of them decide to take the election or all of them reject the choice. One upside from the proposal: it could shore up balance sheets punctured later this year by another FASB proposal on pensions and other postemployment benefit obligations. Along with the "fair value option" proposal, the FASB has recently released Statements 155 and 156, which afford fair value treatment to certain hybrid financial instruments and servicing rights, respectively. There's a lot of commonality among those two standards and the more sweeping proposal, much of it favorable for both preparers and investors. Unfortunately, one common attribute is their "voluntary" nature.

Statement 123(R) holds the promise of putting firms' earnings on equal footing when it comes to their stock compensation reporting practices. That promise of more logical comparisons is ruined by the multitude of firms taking the low road to minimizing stock option compensation by "accelerating the vesting"of existing options. While the reporting of stock option compensation is still a mere quarterly footnote disclosure, these firms are setting the table for reduced compensation expense when Statement 123(R) finally becomes effective, which is in fiscal years beginning after 6/15/2005. When the calendar turns over, they would be charging the remaining value of their existing options against earnings - but these "accelerating firms" won't be recognizing that particular expense. Why? By accelerating the vesting of the options immediately, all of the expense is recorded in the period the vesting occurs. Voila - no stock option compensation to recognize.

The monotonous drone of media reporting about Statement 123(R) might lead one to believe it's been in effect forever. Wrong! It just feels that way - even though some firms with year-ends beginning after June 15, 2005 have been reporting under its requirements for half a year. The great deluge of Statement 123(R) reporting will be upon us when the calendar year companies begin reporting their results for the first quarter of 2006. There are still plenty of nuances surrounding the reporting under the new standard - many of them being global issues, as well as company-specific issues. They're reviewed here.

In the past year, the FASB produced very little in the way of major pronouncements - but added some significant major projects to its already-crowded agenda. The self-interested investor still needs to keep an eye on the FASB's agenda, regardless. Like it or not, the old saw is true: accounting is the language of business and investing. When something is important enough to make the agenda of the standard-setters, investors should want to know about it. Additions to FASB's agenda mean there are problems in current reporting; it means that the language of business is corrupted and needs fixing. Another reason for investors to take an interest: as proposed accounting standards leave the FASB's drafting table and become accounting law, corporate behavior can change. New accounting standards sometimes show a previous lack of managerial restraint in the use of corporate resources - think of stock options, or health care benefits. Paying attention to new accounting standards might tip off investors to a new round of corporate behavior. Want to be an informed investor? Then don't ignore the activities of the FASB. If you're in business, it helps to know the language.

The American Institute of Certified Public Accountants held its annual Current SEC & PCAOB Developments Conference in Washington, DC a few weeks ago, featuring speakers from the SEC, the FASB and the PCAOB. The conference is a major event for auditors of public companies: it's a chance for many of them to hear first-hand from the SEC's staff about nettlesome reporting issues. Auditors want to know these things: forewarned is forearmed when dealing with clients and the SEC, as well. Why burn up valuable audit field time on issues that the SEC has already addressed? Plus, the knowledge provides an upper hand in dealing with sketchy clients: an auditor is perhaps able to trump an aggressive CFO's treatment of a transaction with the hot-issue heads-ups gleaned from this conference. Efficient auditors want the SEC to be their eyes and ears, letting them pick out the accounting issues they might face at audit crunch time. It's worth it to them to spend three days at this conference. As for investors: because the SEC sees the financial statements in the review process well before investors read the annual reports, it makes sense for them to listen to what the SEC has to say. The comments of the SEC staff don't portend disasters. Rather, their remarks indicate there are firms out there that either misunderstand or intentionally misapply generally accepted accounting principles - leading to changes in accounting or restatements of past reporting. Those consequences are not always well-received by markets, and lead to confusion among market participants. For that reason alone, investors ought to be interested in the comments of the SEC staff. Here's what interested the SEC in 2005.

Pensions have been front-burner issues this year as airlines, automakers and auto parts suppliers struggle with the obligations birthed in headier days for the sponsoring firms. First cousin to pension plans are other postemployment benefit plans or OPEBs, for short. They've been part of union negotiations for years, but accounting for such promises didn't get underway until 1992 with Statement 106 Employers' Accounting for Postretirement Benefits Other Than Pensions. Investors run hot and cold on firms' exposure to OPEB plans. Some investors discount them because, unlike pension plans, they lack enforceability under ERISA. Others view them as dangerous earnings-eaters, given that health care costs (the usual OPEB benefit) expand at supersonic speeds. Still others view them warily as earnings management tools because of the highly elastic assumptions rooted in the accounting and the lack of disclosures available to overcome skepticism. This report looks at the OPEB accounting of S&P 500 companies. The overall finding: the accounting for OPEBs fails to deliver clearly meaningful information to investors and analysts. Although there is plenty of information provided, investors and analysts have to do much recasting to the information to get useful insights.

In this first year Section 404 reviews, where most substantially-sized firms dot the i's and cross the t's in their financial reporting to investors, it's ironic that many firms have taken the low road by trying to do an end-run around FASB Statement 123(R). Currently, the compensation expense tied to stock option grants is shown as a mere footnoted amount for most firms; when the new standard becomes effective for all firms in years beginning after 6/15/2005, the remaining value of option grants will actually start being charged to earnings, usually over the remaining vesting period. The end-run? By accelerating the options' vesting immediately, all of the expense is recorded in the period the vesting occurs. By accelerating vesting before the new standard goes into effect, such expense is recorded as a footnote amount, where it's more likely to be ignored than when it's displayed in reported earnings after Statement 123(R) is effective. Is such a move in conformity with GAAP? Certainly - but it's a gamey kind of transaction motivated by accounting outcomes rather than a desire to tell shareholders what was happening in their firm. It's the year's hottest investment fashion: instead of a fleece vest, it's a vesting fleece of shareholders.

Conventional wisdom has it that the costs of Sarbanes-Oxley compliance outweigh the benefits: there's way too much being spent to capture crooks that don't exist, the complaints go. Laws won't change human nature: anybody wanting to exploit the system will do it, anyway. Sarbox punishes everyone for the actions of a few bad actors. The list goes on and on. And plenty of numbers support those gripes: mind-numbing numbers, astronomical increases across the board. How much water is in the numbers can't be told for sure: there's no line on any company's income statement entitled Sarbanes-Oxley compliance expense that gets audited. All the investing public is left with is unproven allegations of costs in excess of benefits. (Make that loud, repeated allegations of costs in excess of benefits.) The increase in audit fees is one Sarbox compliance cost routinely demonized - but it's different in that there really is fairly precise information about those costs in the proxy statements. This report examines those costs - and their changing nature - since 2001 for the S&P 500. A surprise: the auditors aren't necessarily as well off as you think.

When it comes to taxes, the human mind does not always act in the most rational economic fashion. Tax-advantaged financial products seem to frequently strike a chord with individuals and corporations; sometimes, the phrase is like Pavlov's bell causing a salivary response in his dog. Hopes for a tax advantage can entice otherwise sober individuals to make investments they'd otherwise forgo; likewise, for some corporate treasurers and chief financial officers. In a tax system founded on self-reporting of income, there are plenty of chances for those Pavlovian corporate types to report their most pessimistic point of view to the taxing authorities, and their most optimistic point of view to their shareholders - even when they don't believe their pessimistic tax-reporting view will withstand scrutiny. Accounting standards don't provide a framework for presenting uncertain tax positions in a consistent fashion across companies - leading to uneven comparisons. The FASB offers a proposal for leveling the accounting for uncertain tax positions.

Only four brief years ago, Statement No. 141, Business Combinations, rewrote the rule on accounting for business combinations. Probably the most striking change: it eliminated the skeevy pooling of interests accounting method that allowed companies to bury the true value of an acquired operation by recording a combination at the acquired firm's book value. Statement 141 sanctioned only the purchase method of accounting for the acquisition of one firm by another - but left some rather large warts on the methodology's face. Four years later, Statement 141 is being revised in ways both great and small; it'll remove the blemishes that the original Statement 141 left untouched. There will still be only one method of accounting for an acquisition and all combinations will still be considered to be acquisitions - but the end result will be that transactions accounted for under the new, improved Statement 141 will be recorded almost entirely at fair value, 180 degrees differently than was possible under the old pooling method. Furthermore, this standard is a joint project with the International Accounting Standards Board - and will result in a significant accounting standard issued on a common international foundation.

It's widely understood that the income-smoothing mechanics of defined benefit pension plan accounting brings goofy results into the income statement. Scrutiny of expected returns on plan assets was once the province of only hard-core footnote readers; now, even the most junior of equity analysts usually understand that this is not real income to a firm and its shareholders, but more or less an accounting hairball for minimizing reported pension costs and making them less jumpy. In an earnings-driven investment world, the balance sheet doesn't get its due - until it's too late, sometimes. Statement 87 accounting for pensions introduces a surprising amount of pseudo-assets onto corporate balance sheets. There's enough information provided to investors for sorting out pension effects on balance sheets - and in the process, presenting the balance sheet in a way that best depicts the rights and responsibilities of the firm. This report shows how to do it.

There are two truly evergreen issues in accounting. One is stock options, the other is accounting for defined benefit pension plans. Full of legal constructs to begin with, the accounting for defined benefit plans provides plenty of information for investors to evaluate - if they can find their way through the Byzantine disclosures. Investors treated pension plans with indifference during the bull market of the 1990's; they were rattled out of their slumber when the bear market hit and interest rates declined. That whipsaw effect drove investors to worry about pension plans as never before. Since 2003, plan economics have improved - and so have disclosures - but investors still harbor concerns about pension plan effects on corporate reporting and shareholder returns, and rightfully so. Defined benefit pension plans are obscure facets of corporate life that can affect management decisions about capital allocation and even play a role in determination of management bonuses. It makes only good sense for investors to observe pension activity - and that's the purpose of this report.

It's the annual grind: if you want to know how stock options and other stock-based instruments affected the earnings and claims of common shareholders, you've got to spend some time with the annual report. Maybe more aptly, you've got to jump through the looking glass, because the picture you see in the financial statements isn't always what's real. While firms have made great strides in adopting the preferable accounting for stock compensation, there are still plenty of holdouts. Until Statement 123(R) becomes effective, there will be uneven displays of compensation information in corporate reporting - an unevenness that investors should take pains to make level. In this report, the earnings of the S&P 500 are put on a comparable basis for most of the firms in the index, and also presents trends in the way options and restricted stock are being distributed within the S&P 500 firms.

If you think reading annual reports is a dull, unsavory chore for the analyst or investor, consider the alternative: ignorance. That might be exciting. It's certainly easier to achieve. It's plenty easier to think about opening day at the ballpark instead of thinking about opening an annual report. Or a stack of annual reports. The rewards are far greater, though. It's the only time of year you get such a dense dose of information about a firm. Understood properly, digesting the annual report can help you define the risks you're willing to take by letting your capital hitch a ride with the firm's management. The objective is not to simply identify a magical disclosure or two that will tell you at a glance that a company is heading for the skids: the purpose of reading the annual report, if you've already invested in a firm, is to get your bearings as to how the company now fits the investment criteria you've set for it. If you haven't committed capital to the firm, spending quality time with the annual report is how you understand what you're getting into. Simply grinding through an annual report is not enough: you need to figure out just what you want to get out of this year's annual reports for your relevant companies. You need a strategy, and if you're going to look at a lot of annual reports, you need a process. Get that process in place now before the deluge, and get ready to make the most of the annual report season. This report presents a suggested strategy for handling the new annual reports, with an overview of current reporting issues.

Section 404 of the Sarbanes-Oxley Act lit a fire under firms, pushing them to evaluate their systems of internal controls over financial reporting. The Act required more than just mere evaluation of the systems - it also mandated the inclusion of a report on their internal control systems in their 10-K filings, complete with attestation from their auditors as to its working condition at year end. Such reporting is virgin territory for firms, auditors, and investors: until the Enron and WorldCom scandals, internal controls over financial reporting were the unappealing innards of a company. It's the earnings, stupid has always been the mantra for most investors, not It's how the earnings were developed, stupid. That may be about to change, as the new reports land on investors' desks in the next few months. The new reports will provide new views of what goes on inside companies; it might scare the daylights out of investors or just bore them. Here's what analysts and investors need to understand before the reports arrive.

The American Institute of Certified Public Accountants held its annual Current SEC & PCAOB Developments Conference in Washington, DC last month, featuring speakers from the SEC, the FASB and the PCAOB. The conference is a major event for auditors in the United States: it's an opportunity to hear first-hand from the staff of the SEC what kind of problems they've encountered in recent filings. If you're an auditor, that matters a great deal: your objective should be to complete a clean audit on time. Going to the mat with SEC staff eats up the clock - and if you're haggling over issues that the SEC has already warned about, you're going to be professionally embarrassed. (Or should be.) Auditors who are trying to be efficient in planning their year-end engagements want to know just what accounting issues the SEC has found troublesome, and they're willing to spend three days at this conference finding out. The topics covered by the SEC staff do not necessarily signal a WorldCom in waiting - but they still ought to interest investors and analysts. The insights of the SEC staff provide a peek into how companies try cute accounting and put their best foot forward in their annual reports - and that will matter a great deal to analysts and investors in a few months. Because the SEC sees the financial statements in the review process well before investors and analysts, it makes sense to listen to what they have to say. Here's what interested the SEC in 2004.

It's hard to believe, but there were actually accounting issues before the disembowelment of Enron. Sure, you might be able to remember Sunbeam and Cendant - but do you recall Fine Host? Vesta Insurance? Centennial Technologies? Philip Services? Thor Industries? Accounting scandals have been around for ages. While it's true that the magnitude of the Enron affair is unrivaled, it might calm you down if you took a look at some of the major events of the past five years. The following is the Accounting Issues Review that's been part of the last Analyst's Accounting Observer of the last five years. Strung together, you might be surprised at how much you've forgotten in the past five years that seemed terrifying then, but was ultimately survivable. It's certainly not required reading in this new Age of Enron - but it can provide a context for current problems. Some of the aspects recounted should also remind us that, as financial statement users, we're not going to get better financial statements and accounting principles than we deserve. If we truly want good accounting and honest managements, it may be high time for institutional investors to start thinking more like owners and demand better reporting through involvement in corporate governance, instead of relying on the status quo..

It's time for a look back and a look forward at the accounting issues affecting investors in the present. The FASB squeezed a few pronouncements off of its agenda, only to add plenty more than it will likely complete in its next twelve months. Investors need to care about accounting standards for several self-interested reasons. Reason one: while people joke about accounting and its importance, the fact of life is that it's the language of business and investing - and if you don't speak the language, you're at a disadvantage. Reason two: if there's an issue being visited by standard-setters (revisited, in some cases) it's because the current reporting doesn't do the job for investors - or it's been abused by accounting scoundrels. Reason three: as accounting standards move off of the drawing board and are woven into financial statements, companies adapt the structure of transactions to either conform to standards or to dodge them - and if you don't know what the standards are, you're in a weak position to interpret what's going on. It goes right back to accounting being the language of business and finance - so it pays to pay attention.

A little more than two years ago, the financial world was a maelstrom: Enron and WorldCom were revealed to be houses of cards, and auditor Arthur Andersen evaporated along with its shifty clients. The auditing profession - or the accounting industry, to many - drew fire from investors and regulators as never before. At a time when the markets would have welcomed stability and a cool head at the SEC, the Commission offered neither: controversial chairman Harvey Pitt had recused himself from many decisions related to his former clients, the then-Big Five accounting firms. The SEC was in turmoil of its own,while investors wondered who and what the next accounting scandal would involve. The markets continued their bear behavior, begun when the internet bubble broke in 2000 - while interest rates simultaneously declined. The effect on pensions was the widely-cliched perfect storm: declining capital markets reduced the value of pension assets, while low interest rates plumped pension obligations. Investors took to studying pension footnotes with the ardor of a thirteen-year old discovering his dad's Playboy magazine collection. The SEC never really addressed specific pension issues during the Fall of Enron era, probably because there were so many other issues commanding its attention. Perhaps to make up for lost time, the SEC is now investigating pensions - and other postemployment benefit plans, as well. The pension issues of the S&P 500 have been addressed in a previous report; this one is devoted to their OPEB issues.

The accounting for other postretirement benefits is rife with estimates; in their discussions of critical accounting policies, firms frequently cite other postretirement benefits obligations as an accounting estimate concern. And well they should: a firm not only must project the term over which it will pay health care benefits, it must also guess the trend in health care costs. Those estimates are the source of endless debates about too high or too lowfigures, but most would agree that the end result - the calculated obligation - is a significant number at many companies, bearing negative future cash implications. If you recall your accounting history from the early 1990's, remember that accounting for other postretirement benefits earned almost as much revulsion from public firms as the present proposal for recognizing stock option. In late 2003, a dream came (partially) true for corporate sponsors of these benefit plans: the Medicare Prescription Drug, Improvement and Modernization Act of 2003 was signed into law, promising to subsidize them for certain prescription drug plans. Companies affected by the Act find themselves in the enviable position of having to reduce their recorded benefit plan obligations - and part of the package is a nice ongoing earnings fillip. The accounting for the change is effective in this current reporting quarter. Investors need to understand that it can provide added juice to some firms' net earnings in the quarter, and interpret it separately from other cost activities.

For the past few years, companies have been required to address their critical accounting policies in the Management's Discussion & Analysis section of their annual SEC filings. It's not an eye-catching disclosure: it doesn't deal much with numbers, the lifeblood of most financial analysis. It is, however, an interesting bit of self-diagnosis. The SEC is essentially asking companies to describe the accounting policies and estimates that have the greatest impact on the financial statements. The disclosures should tell investors where accounting risk resides in the firm. Individually, the discussions run the gamut from mere compliance boilerplate to adding genuinely useful insights into a firm's workings. Collectively, the disclosures enable you to do some corporate mind-reading on the market as a whole. Tabulating the disclosures for the S&P 500 shows that the biggest corporate accounting risk is in the area of income taxes, followed closely by revenue recognition - and the tech sector has the highest concentration of critical accounting policies overall. Those concerns are straight from the horse's mouth, not from some talking head spouting his or her opinion of where accounting risks lie. It's information that helps an analysts or investor set their own worry and study priorities.

Analysts and investors view firms through different prisms of profitability; anyone making a significant investment is concerned with the source of the firm's earnings. Do they originate in a particular segment? Or is there a particular segment that sops up the profitability? How will the different segments perform in the current economic environment - or the one expected to occur? There's one view that analysts and investors usually don't see. Firms following U.S. generally accepted accounting principles do not record deferred income taxes on certain foreign profits because of an obscure exception in a tax accounting standard. Those untaxed foreign profits pile up year after year, and can stoke earnings growth handsomely. As the FASB plows forward with its goal of converging U.S. accounting standards with international standards, this exception might be eliminated - and so will an ersatz growth source and potential earnings management tool.

One of the memorable legacies of the Clinton administration was the revelation that there could be so many possible meanings of the word is. If you recall, the 42nd President of the United States responded to a question with a response that went something like, It depends what you mean by ˜is'. Some of us still puzzle over the many communication possibilities presented by such a tiny word; perhaps we've never been quite aware of how badly we've been misunderstood by people who took the way we meant is as opposed to the way they understood is. So it is (there's that word again) in accounting: for years, the term fair value has been scattered throughout accounting literature and accounting-speak, without much consideration that it might have different meanings in different contexts. For the first time, the FASB is proposing a uniform definition of fair value in all of its existing standards, one that will mean the same thing in all standards as the board develops new ones involving fair value measurement.

Defined benefit pension plans are amorphous constructs that introduce all kinds of vagueness into performance reporting. Hard to get one's arms around them, full of accounting jargon, and related to promises often made without consideration of the consequences, they've generated fear and loathing among investors just because of the uncertainties they inject into the income statement - and because of the uncertainties they raise about future cash flows. Full of abstract and fuzzy concepts, over the last few years they've provided investors with the proverbial poke in the eye with a sharp stick. An intangible sharp stick, but investors felt it nonetheless. In 2003, a strengthening stock market plus employer commitments to increase contributions to underfunded plans placated many investors' fears. As they watched the stock market climb, investors worried less about the funded status of pension plans and ill effects of increasing contributions. At the same time, interest rates were still trending lower, powering more growth in projected benefit obligations. By year end, maybe investors shouldn't have been so sanguine: as a group, the underfunded pension situation had barely improved from 2002. Investors also felt more comfortable that firms were using more realistic asset earnings assumptions - but the basic flaws in the reporting of pension cost remained unchanged. In short, while there was plenty of improvement in the pension situation - particularly visible due to the new disclosures required by Statement 132(Revised) - there's still room for much more improvement in both the management of defined benefit pension plans and the reporting of their effects on corporate sponsors. This report takes a look at corporate pension funds as they really are at the end of 2003 for the S&P 500 and also how they affected reported earnings.

Call it the cash substitute without the high price. Dip into the ownership stake of those who own the firm to pay those who run it, and you won't have to dip into the treasury to use cash. Spread it around like butter, year after year: shareholders rarely notice the creeping dilution. In case they ever notice, their attention is diverted easily enough with an eye-popping earnings report or a blowout acquisition. Firms are using less of the option brand of margarine currency these days, and frequently switching to restricted stock nonetheless. One might gripe that restricted stock issuance is still a form of shareholder pocket-picking, but at least it's more honest: the shareholders get to see the effects of restricted stock grants in the income statement. Despite the voluntary options expensing movement, most of the grifting that is option issuance is still suppressed from financial reporting - as if the options awarded had no value to the holder, no cost to the issuer. If they're so darned worthless, why are they supposed to be such great motivating tools? Make no mistake about it: options visibility in earnings is improving. Until the FASB's proposal to revamp equity-based compensation becomes an accounting law (by no means a done deal), investors will still have to muck through the footnotes if they want to see what it takes to run a firm when all costs are counted. This report is the result of that mucking-through process: it's a look at the earnings of the S&P 500 as if a single, consistent basis had been used for all firms' stock compensation accounting, and also presents trends in the ways stock options are being issued and valued, along with trends in restricted stock issuance.

A festering wound has lingered on the body of accounting literature for over half a century: the non-recognition of compensation expense for stock options granted to employees. Many companies have considered the flawed accounting their birthright, particularly those in the technology industries; they have resisted improvements in accounting for the compensation expense with stunning ferocity. Shareholders can only wish that their firms had competed in their respective marketplaces with the same zeal. The free ride is coming to an end. During the gestation of Statement No. 123 in the early 1990's, technology firms skillfully maneuvered Congress into threatening the FASB with its existence. The exposure draft of that standard required compensation expense recognition for grants of stock options; its official, emasculated version required only footnote disclosure of those effects. Nine years after its issuance, FASB is shoring up the limp Statement 123 with amendments that require expense recognition of options, along with a raft of technical improvements. Barring either unexpected fatal flaws in the exposure draft or last-ditch interference from Congress, the exposure draft should result in a final standard around the fourth quarter of 2004, becoming effective in January 2005 for companies with December year ends.

There are two seemingly eternal issues in financial reporting. One: how does low-brow reporting of options compensation distort performance results? Two: how does pension accounting distort performance results? These questions haunt investors and analysts each year at annual report season, when the disclosures about the two accounting vexations are most plentiful. A look at the top 150 companies in the S&P 500 yields some intriguing answers. Those 150 companies - less than a third of the total 500 - comprise over 70% of the entire group's total market capitalization. All of them have some form of stock compensation and 120 of them have defined benefit pension plans - so it's a fairly representative group of the larger whole. The early findings? The popularity of options compensation has waned as you might have expected - but restricted stock is gaining in popularity. More compensation in all forms is what counts, apparently, and not just the form of more compensation. As for pensions, assets rebounded handily in 2003, thanks to a bull market and hefty contributions - but pension obligations continued to grow unabated.

If capital knows no borders, shouldn't financial information about companies be consistent across borders? For years, convergence of accounting standards between the United States and the rest of the world has been bandied about as the logical extension of globalized markets. Standards of the rest of the world has gradually come to mean the issuances of the International Accounting Standards Board (IASB). You'll be seeing those standards in plenty more foreign financial statements beginning January 1, 2005. That's when all companies in the European Union will be required to use those standards in their publicly-filed financial statements - something on the order of 6,000 companies. Another boost will come from Australia at the same time, as they institute the same requirement. Back to convergence: the U.S. accounting standards created by the Financial Accounting Standards Board (FASB) are not the same as the IASB standards, as you'd expect. Getting the two sets of standards synchronized will take years of work, a task begun in the mid-1990's when the FASB collaborated with the IASB's predecessor (the International Accounting Standards Committee) in writing a common standard for earnings per share. The two standard-setters committed themselves more fully to convergence of their standards in September 2002. The first fruit of that commitment is a series of proposed amendments to FASB standards that will make them more like existing IASB standards. They're small steps - just a few inches in a game measured in yards - but every one of them is superior to the existing practice in U.S. generally accepted accounting principles in subtle, surprising ways.

For analysts and investors, there's a lull between the fourth quarter earnings season and the Final Four (the basketball kind, not the auditor kind) - a lull before the springtime storm of annual reports. Don't get too relaxed: that springtime storm starts earlier than usual. The SEC requires companies with calendar year-ends to file their 10-K reports by March 15 this year, early enough to interfere with your Final Four plans if you're an ardent annual report reader. (Though for most folks, it works the other way around.) If you're not an ardent annual report reader, slack at your own risk. There's no other time of year you'll receive corporate information as richly informative as the annual report. The beauty is not just in the details: read these economic epistles with a wary eye and you just might find challenges to your beliefs about a company - or its management. You just might find a disclosure or two that tweaks your fear factor and makes you bail out of a stock before the company disappoints investors, or worse, flames out it in shame leaving a trail of shattered, bitter shareholders in its wake. Hyperbole aside: finding a magical fact that lets you sidestep an extreme loss should not be the point of reading annual reports. Knowledge is a cumulative asset that helps investors understand the economics for companies and the industries in which they play - and that develops the ability of an investor to assess reasonableness of expectations for companies and industries. Call it smarts, experience or wisdom - there's no better way to develop your knowledge base of companies and industries than going directly to the source: the annual report. Take advantage of the pre-Final Four lull to figure out just what you want to get out of this year's annual reports for your relevant companies.

The American Institute of Certified Public Accountants held its annual Current SEC Developments Conference in Washington, DC last month, featuring speakers from the SEC, the FASB and the AICPA. For the first time in two years, a Chief Accountant of the SEC was actually in place and present at the affair, along with other speakers from the Office of the Chief Accountant and Division of Corporation Finance. The conference enables the SEC staff to warn thousands of auditors for publicly-traded companies about the financial reporting practices they consider unacceptable, just in time for the year-end audit season. Whether they're smart (or just plain scared), auditors spend nearly three days at this conference trying to raise their accounting IQ. Analysts and investors and investors can raise their accounting IQ as well from the missives preached by the SEC's staff; they need to stoke their skepticism when it's their turn to review annual reports in a few months. Consider this: if the SEC staff considers an issue important enough to flog with auditors at an accounting Woodstock, it might portend an emerging trend or two in financial reporting - something to bear in mind as one studies annual reports or listens in on earnings calls. The SEC sees the financial statements through the review process before investors and analysts, so if they're spotting poor reporting, it makes sense to listen up. Here's what the SEC saw in 2003 - and doesn't want to see any more.

Accounting issues receded from investor memory in 2003 - but only slightly. Firms with weird futuristic names like Enron didn't dominate scandal-filled headlines; instead, the biggest accounting scandal headlines of 2003 belonged to a firm with the comforting sobriquet of Steady Freddie. Management's dogged pursuit of a ruler-like earnings stream proved to be its undoing. Freddie Mac's derivatives-driven accounting monkeyshines were among the most notable in recent times because they occurred in an institution that most investors considered to be a conservative sort of business. They weren't the only accounting-related story of the year, however. Plenty more happened in that twilight zone between the worlds of accounting and investing - two worlds that affect each other acutely, even though their denizens act like there could never be anything in common between the two. Read on for a brief tour through the accounting events of the past year, culled from the pages of The Wall Street Journal and the New York Times.

The year's almost passed, and there haven't been many new accounting standards - at least in terms of sheer numbers. In terms of sheer anxiety on the part of preparers and auditors, however, there's been plenty as they ready themselves for implementing the ones that were issued in 2003. FASB Interpretation No. 46 and FASB Statement No. 150 generated that anxiety, and in truth, were the two most noteworthy standards issued by the Board in 2003. Only two noteworthy standards in a year? You might think there's no sense of urgency at the FASB in a Sarbanes-Oxley world. Nothing could be further from the truth, and the evidence is found in the FASB agenda for the coming year. It's quite an ambitious set of goals.This report summarizes the more critical pronouncements of the year and previews what lies ahead for companies and analysts as the FASB progresses on its 2004 plans.

Return on equity is an old standby of a performance yardstick for equity investors, and with good reason - it's simple, consistent and tells a story about performance in straightforward fashion. Investors almost take it for granted because of its simplicity. In short, the figure gives a quick summary description of what management has done for shareholders lately. While it has its shortcomings and its detractors, it's a measure that's not likely to disappear from common use anytime soon. One shortcoming: elective accounting standards (stock option accounting, for instance) and arguable accounting standards (pension accounting, for instance) can significantly affect the figure. Another shortcoming: changes in accounting principles, over time, will also introduce biases into the figures. If you aren't careful to filter out those effects, you just might get the wrong signal from the return on equity figure. This report shows how some of these variables have affected return on equity in the S&P 500 over the last five years - and highlights the differences stemming from accounting as opposed to performance.

Enron showed the world the power of an idea: if investors can't see it, they can't ask you about it, - the it being assets and debt. That company nearly perfected the art of off-balance sheet financing, and its demise led to a rapid reconsideration of some of the accounting rules for consolidated financial statements. The reconsideration led to last January's issuance of FASB Interpretation No. 46, Consolidation of Variable Interest Entities. Call it FIN 46 for short. Call it a principles-based standard as well: judgment aplenty is required to evaluate whether or not an outfit is a variable interest entity, or who is its primary beneficiary. Those determinations make the critical difference between assets and liabilities remaining off-balance sheet or being displayed in full sunshine. The standard was not well-received by financial statement preparers, and their repeated howls for more guidance have been ultimately satisfied: on October 9th, the FASB postponed FIN 46's implementation for another three months. Superficially, it appears that the FASB caved to pressure, but the underlying reason is more practical: the SEC is not sure it's ready to handle the wave of new registrants or changes in registration that FIN 46's application could trigger. Meanwhile, investors and analysts still grapple with foggy disclosures about the expected effects of FIN 46 adoption and uneven comparables: some firms have adopted it while others are waiting until the last minute. This report is a review 10-Q MD&A discussions of the issues surrounding FIN 46's application for S&P 500 companies.

Like a buggy version of Windows, Statement No. 87, Employers' Accounting for Pensions has driven its users batty for years. Waiting for the annual information to see how pension plans affected the earnings of the sponsors is much like the insufferable wait for your computer to reboot after a blue screen of death. Investors and analysts handled the barmy information in annual reports the same way they handled the snarled software on their computers: they gritted their teeth and conformed to the behavior forced on them by the very tools that were supposedly serving them. There simply have been no practical alternatives to either kind of standard. From time to time, Microsoft issues service packs designed to repair flaws in Windows and give it more stability and utility. That's another similarity between Statement No. 87 and Windows: in 1998, FASB issued Statement No. 132, Employers' Disclosures about Pension and Other Postretirement Benefits, to clarify and bolster the pension accounting disclosures. Call that pronouncement Service Pack 1: something that helped, but didn't chase away all of the gremlins. The improvements were insufficient in providing answers to the multitude of pension questions raised in the last few years. As the recent pension panic revealed more of Statement No. 87's flaws, FASB returned to the drawing board and whipped up a new exposure draft: call it Service Pack 2. Investors and analysts would be wise to examine the benefits and shortcomings of this new patch - before they have to live with it for years to come. A tech support call to FASB: instead of patching up a legacy standard, give users a whole new operating system.

In the classic comic strip Li'l Abner, shmoos were blobby, shapeless little critters that existed only to please mankind - even if it meant self-sacrifice, which was delicious bounty for humans. Every part of a shmoo possessed value for everyone in mythical Dogpatch. The real-world equivalent of the shmoo is the defined benefit pension plan. Like the amorphous creature in the comics, the formless defined benefit pension plan likewise provides sustenance for retirees, asset managers and pension consultants. For the managements of companies sponsoring the plans, the pension accounting standard governing these financial shmoos provides legitimized earnings management tools. Over the past couple years there's been much panic over perfect storms battering defined benefit pension plans or the pension monster that will suck available capital away from shareholders and into pension funds. For all the fretting, defined benefit pension plans are still shmoos, albeit shriveled ones by this time. Even in their wizened state, they still provide nourishment for their beneficiaries - and they still introduce near-comic economics into the financial statements. The worst may be behind defined benefit plans: this year's stock market performance, combined with the year-to-date rise in long-term bond yields, should alleviate the underfunded status of many plans. Nevertheless, there's still much to cause concern - and to relieve concern. While many grumble about the lack of clarity surrounding pension accounting, there's still a wealth of information available to get the right perspective on pension issues. The shmoo is ever-present in the financials, but not always benevolent to the analyst or investor; using the right measurements buried in the notes helps an investor flush out the rascals.

The more tone-deaf among us can't recognize a trumpet from a trombone, or a snare drum from a base drum. A hearing aid wouldn't do these poor souls a bit of good; they'd only hear the same indistinguishable sounds, only louder. The aural integrity of these musical instruments is wasted on these folks. Certain financial instruments are used by companies to produce the financial statement equivalent of tone-deafness in analysts and investors possessing otherwise keen senses. How? Financial instruments such as mandatorily redeemable stock, agreements to repurchase equity shares, and some obligations to issue a variable number of shares all have one thing in common: they toy with the presentation of liabilities versus equity. Classifying debt instruments as equity just because they wear an equity wrapper puts the balance sheet into an off-key mode. Instead of playing music for investors, the balance sheet sings a siren's call: I'm not reeeeally overextended... FASB Statement No. 150 puts some of these financial instruments into their rightful place on the balance sheet: back into liabilities. It should make a difference in the appearance of some financial statements as early as the second quarter, with broader application expected in the third quarter. Some sour notes might be heard if resulting debt ratios get out of hand.