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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.
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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.
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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 alert. While more fair value reporting will generally be a good thing for investors, there’s going to be non-comparability in reporting between those firms taking the fair value option and those that don’t. Furthermore, the standard gives firms latitude to selectively apply fair value reporting - so those who take the option might be only employing fair value accounting when it works to their advantage.
Investors need to understand how financials could be affected by the “fair value option” in order to assess whether a firm is genuinely better off from its application, and to take into account differences between the earnings of firms choosing the option and those that do not. They’d better do it soon: while it’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. More Info |
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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.
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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. More Info |
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