The Accounting Onion

FAS 157: The FASB's Prelude and Fugue on Fair Value of Liabilities

FAS 157 on fair value measurements was supposed to provide comprehensive guidance for determining the fair value of pretty much any asset or liability.  Yet, almost two years after its initial publication, and well after companies have had to apply the standard to certain accounts, CFO.com reports that the FASB is still making up some of its rules on the fly, and having a tough slog to boot.  The problem described in the article has immediate consequences for derivative financial instruments that are classified as liabilities, but it could eventually affect the measurement of many other liability accounts as fair value measurement becomes more broadly applied:

"At an unusually heated FASB meeting last week [no minutes published on the FASB's website yet], for instance, the members debated how companies should estimate the market value of liabilities when there's no actual market on which to base the estimate.

During one point in the discussion, which concerned a proposed guidance by FASB's staff on how to mark liabilities to market under 157, chairman Robert Herz seemed, to member Leslie Seidman, to be contemplating an overhaul of the brand-new standard itself. Matters got so confusing that the board ordered its staff to go back and summarize the members' positions so that they could understand what they themselves had said.

At issue was the question of how to measure the fair value of a liability for "which there is little, if any, market activity," according to 157. The standard defines fair value as "the price that would be received ... to transfer a liability in an orderly transaction between market participants at the measurement date." The question that FASB struggled with was: How do you determine the fair value of a liability that can only be settled, rather than sold?

...Often, for instance, when a company borrows money, it can't transfer its obligation to another party without an agreement from the bank. Or a market may not exist for transferring such liabilities."

It's a mess that the FASB has gotten itself into for two related reasons.  The first is that the problems now being addressed are significant, and they were known long before FAS 157 was let out the door. The second is that FAS 157 is fundamentally flawed in its approach to fair value measurement of liabilities.  The solution, as I am about to describe, seems to me to be surprisingly simple. 

This particular flaw in FAS 157 (see my previous post on many others) occurs in paragraph 5:

"Fair value is the price that would be received to sell an asset or paid to transfer a liability [italics supplied] in an orderly transaction between market participants at the measurement date." 

For every liability there is a counter party that holds an asset, and the economic value of the liability must be equal to the economic value of the asset. These are basic economic principles, which are not acknowledged in FAS 157.    If they were acknowledged, there would be no need for the phrase "or paid to transfer a liability."  That's because the value of any liability -- even one that cannot be transferred --must equal the value of the counter party's asset, which, perforce, can always be transferred.  Even though the evidence directly available to value the liability may be scant, the asset value might even be quoted in the newspaper; the non-transferability restriction on the debtor is just one more valuation parameter from the viewpoint of the creditor. 

If you need further convincing that the solution to the problem of valuing any liability is to value the counter party's asset, let's consider an even thornier non-transferable liability that the FASB briefly considered and then dropped like a hot potato:  contingent environmental liabilities.  My understanding of federal environmental law is that the cleanup liability of a "potentially responsible party" is joint and several.  No other party can assume the liability, so the only way out from under it is to settle with the government.  Although I am not aware that the government has done this, it is theoretically possible for the government to transfer its contingent receivable to a third party.  Is the contingent receivable difficult to value?  Yes, but certainly no harder than many of the complex, illiquid derivatives that are roiling the global economy.  (And by the way, I recall seeing the issue of the fair value of contingent environmental liabilities posted on the FASB's website during the project phase of FAS 157.  The Board expressed a tentative conclusion, but it soon disappeared mysteriously, and without explanation.  I have searched Board minutes, and have come up with nothing.  If anyone has any further information on this that they would like to share, please contact me!)

Because my solution to liability valuation is so simple (attention: CIFiR - SEC Advisory Committee on Improvements to Financial Reporting) and obvious, I can't help but fear I have overlooked something.  If that is indeed the case, I hope a reader of this post will take the time to point it out, and I will gladly issue a mea culpa forthwith.  Yet, I derive some measure of comfort (and optimism) by an entry in the minutes of an FASB meeting (11/14/07) where Bob Herz stated that he disagrees with the measurement principles for liabilities in SFAS 157. 

Who knows, maybe Bob and I are thinking along the same lines?  That gives me hope for the future.  But, I have to express my disappointment that liabilities were not dealt with in a comprehensive way before SFAS 157 was issued. There is much to be said for getting it right the first time.

SEC Settlement with Auditors of WorldCom: Too Little, Too Late?

Coming on the heels of accusations that the SEC is trending toward less vigorous enforcement against financial reporting violations, the SEC published here and here its settlements with the two Arthur Andersen partners that planned and supervised the 2001 audit of WorldCom.  Six years later, the settlements amount to little more than slaps on the wrist:  both auditors were suspended from practicing before the SEC for at least three years, no monetary penalties were assessed, and no admissions of guilt were obtained.  (By the way, one of the auditors has let his CPA license lapse, and the other is still licensed as a CPA in Mississippi.)

I have three questions for the SEC.  First, why were these individuals allowed to settle without admitting or denying guilt in what appears to have been an open-and-shut case?  Second, why were no monetary penalties assessed?  Third, why did it take six years, with only this so-called "settlement" to show for all this time and, presumably, effort?

I'll leave any kind of thorough treatment of the last two questions for future ruminations (feel free to do it without me!), and will focus henceforth on my dissatisfaction with a settlement that does not require auditors to admit to the public that they made inexcusable mistakes -- in what was apparently a slam-dunk case. 

Background

Most readers will recall that the WorldCom accounting fraud was astonishing for both the magnitude of the errors in the financial statements, and the simplicity of the accounting.  We're not talkin' 'bout complex financial arrangements, arcane consolidation, pension, stock option or revenue recognition rules; we're talkin' the third week of Accounting 101.  We're talkin' about capitalizing telephone line access fees ("line costs") that should have been expensed.  Over a number of quarters, $3 billion in payments that should have been reported as expenses on the income statement were parked in property and equipment (P&E) accounts on the balance sheet.  The "top-side" accounting entries to effectuate the fraudulent misstatements circumvented internal controls and were made by accountants with the highest authority in the company.   

The $3 billion capitalization of line costs was the first of the WorldCom accounting frauds to come to light, but it paled in comparison to the additional $8 billion of accounting misstatements that were subsequently discovered.  As Cynthia Cooper, the whistle blower on the first $3 billion wrote in her recent book (I reviewed it here):

"...[top management at WorldCom] had a process called 'close the gap,' whereby they would compare quarterly revenue to Wall Street expectations, analyze potential items they could record to make up the difference, and book revenue items that had not been booked in the past."

Given the magnitude of the misstatements, it doesn't seem possible that they could have occurred in the absence of a broken audit.  The two Andersen partners on the WorldCom account were charged with violating the SEC's own rules of professional conduct as they apply to accountants* who practice before the Commission: Rule 102(e). That also should have kept things relatively simple, as the case would be made before an administrative law judge; no interaction with the courts or other government agencies would have been required.  I'm not a lawyer, but I think that the threshold standard of proof in such a case would have been the same as civil litigation, "preponderance of evidence."

Also, the SEC reached only for the low-hanging fruit when bringing their charges against the two audit partners, both of whom had been involved with WorldCom for a number of years.  Basically, in addition to intentional, knowing or reckless conduct, the most difficult to prove, there are two other ways that an accountant can violate Rule 102(e):

1. A single instance of highly unreasonable conduct that results in a violation of professional standards in circumstances in which the accountant should know that heightened scrutiny is warranted, or;
2. Repeated instances of (merely) unreasonable conduct, each resulting in a violation of professional standards that indicate a lack of competence.

The SEC wisely chose the second of these two.  All they wanted, and needed, to address was conduct in violation of the equivalent of the third week of Accounting 101, plus the third or fourth week of Auditing 101. At the risk of being tedious, but to educate my readers who are taking Auditing 101 and to make the point that the SEC must have had a slam-dunk case, here is but a sample of the SEC's allegations:

• Andersen discovered fraud of a similar nature a year earlier, and affecting the same PP&E accounts.  There were other strong indicators that fraud might occur, like the financial straits of the CEO, a history of aggressive accounting, and industry factors.  Consequently, the engagement team classified overall audit risk as "maximum."  However, substantive tests of PP&E , one of the most significant balance sheet categories, were not expanded.
• The auditor's did not design or implement procedures to review top-side entries, evidently relying on management's representation that there were no significant top-side entries--even though fraud via top-side entries took place just one year earlier. 
• Additions to the PP&E accounts were only examined through the third quarter of 2001, and not as of the end of the fiscal year.  $841 million of the fraudulent charges to PP&E occurred in the fourth quarter.
• A reconciliation of beginning and ending PP&E balances was not done.  If the auditors had done so, they would have discovered that the $3 billion in fraudulent charges to PP&E were made in circumvention of normal approval processes.
• The expense accounts that were reduced by the top side entries were not reconciled to the financial statements and general ledger.  "Had they done so, the auditors would have discovered that the line cost expenses they were testing were significantly larger than the line cost expenses reflected in WorldCom's financial statements and general ledger."

Back to the Question

Let's be generous, and presume that those who pull the levers at the SEC subjugate their personal interests for the public interest.  Indeed, one could argue that there have been many cases where the SEC obtained the same monetary fines and sanctions -- or maybe even more -- in a settled action than it could have gotten in court.  One of the reasons this may be the case is that many defendants have an economic disincentive to admit guilt in an SEC action.  That's because (once again, I'm not a lawyer) one who admits guilt to the government may not deny it in a private action -- where the money penalties could be much bigger. 

So, in many instances, it may actually serve the public interest to give defendants the option of settlement with the SEC without an admission of guilt; but, my point is that it is certainly not always the case.  Now, ceasing to presume motives as pure as the driven snow, the SEC counts scalps, and a settlement containing an agreement to be sanctioned, however meaningless, counts as a scalp to be hung up before Congress and the world.  Fewer settlements mean more trials, and more trials mean fewer scalps. Even considering the predisposition for scalps of any color, this case took six years just to get settled! And, how many defendants are coerced into settling without admitting or denying guilt just so the SEC can have their scalp, even though the accused parties truly feel they did nothing wrong, but need to get the matter put behind them? 

Focusing specifically on the case of the WorldCom auditors, I can't possibly see how the public interest was served by settling without a fine, and without an admission of guilt.  If there was ever a case where the SEC could have sent an unequivocal message by making its case in court, this one was it. Can anyone say that more was gained by settling? Given the magnitude of the numbers, timing and other circumstances, can anyone say that the public does not rightfully want to know whether and how WorldCom's auditors violated the basic standards of their profession? 

And, not only is there a message opportunity, the public deserves more justice and closure.  Will private litigation against these auditors take place?  I doubt it, because their pockets probably aren't deep enough to fund the private attorneys.  Therefore, the argument of a defendant loathe to settle because of exposure to private litigation goes poof. Will the AICPA or state accountancy boards discipline these auditors?  It's been six years, and so far not a peep from them either -- just one more reason we need the PCAOB.

For the SEC, it shouldn't be about the money they collect in fines, or the number of years of sanctions they obtain from settlement, or even (and this is, I admit, controversial) about the sheer number of cases they bring.  It should be about deterrence: the message sent by a case that will contribute to greater trust in the capital markets by reducing the risk of fraud.  The reality, though, is that it is very convenient and self-serving to measure and report monetary fines,** volume of cases and years barred from practicing before the Commission.  The flip side of this reality is that one cannot possibly measure how many frauds did not occur because of the threat of vigorous and consequential law enforcement. Ergo, the focus of bureaucrats on scalps; in the case of the 2001 WorldCom audit that misplaced focus results in giving unduly short shrift to deterrence.   

-----------
*Note to students: the SEC rules of professional conduct apply to all accountants at public companies -- not just their auditors.

**Well, maybe you can't always measure the effectiveness of the SEC by the fines they mete out. See Jonathan Weil's commentary in bloomberg.com on how he believes SEC Chair Cox inflated the numbers he reported in recent congressional testimony.

More on the CAQ Survey

I thought I had beaten flat the CAQ's survey of audit committee members in my last post.  Lo and behold, here is one more nasty tidbit brought to my attention that merits sunlight.

Among the organizations that with whom CAQ partnered for the recruitment of survey takers was the National Association of Corporate Directors (NACD).  NACD must know who among its members are on audit committees; nevertheless, it blithely sent CAQ's survey out as a mass mailing to all of its 17,500 members.  As you may well have anticipated, there were no controls to ensure that the survey would be responded to by audit committee members only.

OK, so maybe not all respondents were actually members of audit committees -- big deal. But, what if respondents weren't even members of a corporate board?  According to the NACD website:

"NACD accepts both individual and full board membership. Associate membership is available to professional services organizations -- such as legal practices, audit firms and compensation consultants -- who provide essential board guidance and advisory services." [italics supplied]

Recalling that CAQ based their statistics on the responses of only 253 volunteers, how many of these volunteers weren't even board members?   What if 50 of the respondents were actually audit partners?  My point is that they survey methodology was so loosey-goosey, we have no way of knowing. 

Gatekeepers Hoodwinking Gatekeepers

As Bejamin Disraeli said, "There are three kinds of lies: lies, damned lies, and statistics."  Perhaps statistics is the most insidious of the trio because they can be the most beguiling.  The CAQ sits at the same point on the Disraeli scale as any other lobbying organizations who conciously produce data that they intend to be mistaken for information.  But, there should be an important difference: the CAQ is controlled by audit firms who, according to the "P" in "CPA", purport to be ethically bound to protect the public interest.  When journalists are hoodwinked by CAQ into reporting on mere data as if it were information, then CPAs have failed to live up to the ethical standards of those who fund it.

Journalists also function in a large sense as gatekeepers for misleading information.  How ironic is it that CAQ, an organization funded and controlled by audit firms, was so facile in its manipulation of other gatekeepers?

Low Quality Stats from Center for Audit Quality

Much ado has been made lately of the insubstantial contribution business school professors have made to practice through research.  Accounting research of the last forty years, being no exception, was blasted in a commentary in the Chronicle for Higher Education for not addressing questions relevant to accounting professionals.  The authors, academic accountants themselves, blame universities for not providing more robust incentive systems to encourage a broader range of topics and methodologies. 

I want to add another reason:  practitioner organizations barely give lip service to academic research, because their members actually don't want to know what academics have to say.  That's because the truth can be so darn inconvenient (apologies to A. G.).  Just recently, the Financial Accounting Foundation says it doesn't believe it is necessary anymore to have academic representation on the FASB (see earlier post); and now a new report by the Center for Audit Quality (CAQ) presents the results of their "commissioned" survey of audit committee members.  "Research," by any standard academic, it ain't.

I have two problems with the survey.  First, the survey methods are so crude, that if an academic had tried to present this work to peers as serious research, either his sanity or intelligence would be called into question.  Second, the presentation of the "key findings," such as they are, have been skewed to fit the public relations agenda of the accounting profession:  post-Enron rehabilitation of auditors' reputations, and entrenchment of the revenue-producing aspects of SOX.  Other than these two criticisms, the report is just fine.

Let's start with the methodology:

Non-random sample -- CAQ states, without explanation, that it was "not feasible from a cost or time standpoint" to take a random sample.  How ironic is it that an organization sponsored by auditors would forgo random sampling, the indispensable basis of so many auditing standards, procedures and concepts?  CAQ blithely asks us to assume this is a minor detail:

"With a pure probability sample of this size, one could say with ninety-five percent confidence that the overall results would have a sampling error of +/- 6.2 percentage points.  As this survey is not a pure probability sample, theoretically no sampling error can be calculated."

Setting aside that calculation of a sampling error is not "theoretically" possible (read simply as "not possible in any way, shape or form"), +/- 6.2 percentage points is actually a pretty large number that can affect one's reading of the results.  Maybe that's why it is not mentioned again in the report.

Sample size -- Let's agree that the population of interest, audit committee members of public companies, number very approximately 10,000.  Only 253 of them volunteered in response to invitations to participate.  Given the low participation level, it is highly likely for non-respondents to have significantly different opinions than the self-selected volunteers.  If anything was done to test that proposition (yes, academics routinely apply techniques for doing so), CAQ did not report it.

Sample demographics -- CAQ gathered very little information about the respondents.  We know virtually nothing about their financial or accounting expertise.  For example, how many are "designated financial experts"?  How many are former auditors? 

We do know, however, that 44% took their first position on an audit committee post SOX.  As some of the key survey questions ask their opinions about the pre- and post- SOX environment, their opinions may be different, or even less reliable, than the respondents with longer tenure on audit committees.

Wording of the questions -- Let's say you joined your first audit committee in 2007.  How would you respond to this key question:

"Based on your experience as an audit committee member [italics supplied], how would you rate the overall quality of audits of publicly traded companies being conducted today?

First, I don't know if a respondent could reliably separate their audit committee member experience from their prior experience.  Second, given the variability in length of tenure of audit committee members -- some pre-SOX, and other not -- it appears as if two populations are being combined into one. 

The next survey question is:

"And over the past several years, would you say that the overall quality of audits of publicly traded companies has...?" 

Assuming that the "based on your experience" language carries forward, how is the newbie audit committee member supposed to answer that?  Dunno.  Remember, these folks are 44% of the respondents!

Integrity and Objectivity Red Flag -- Neither the organization that purportedly conducted the survey was disclosed in the survey report, nor the scope of their responsibilities.  Imagine an audit report not identifying the auditor; this is not much different.  Was the contractor a well-respected company that didn't want to be associated with the end product?  Was it an organization with other ties to CAQ?  Just asking.    

Now, on to the reported "key findings"

Current state of audit quality -- The audit committee now appoints the auditor and reviews their work much more closely than in the pre-SOX era.  What board member would be willing to admit, even anonymously, that their choice of auditor was a mistake?  So, it's not surprising that CAQ finds that 95% of respondents rate their auditors' work as "good" or better.  As a "key finding", it's a big fizzle. 

The other side of the coin is more provocative: a client paying top dollar for audit services should not be satisfied with work that was only "good" or "fair." That's how 22% of respondents saw it.  Moreover, 17% said that the situation had not changed or worsened since the passage of SOX. 

Risk of fraudulent financial statements -- CAQ blithely reports that 87% of respondents believe the risk of releasing financial statements that are materially inaccurate due to fraud is not very high.  That's a good thing?  I don't think so, especially when you consider that these are audited financial statements!  Has SOX affected the potential for fraudulent misstatements?  The CAQ would like you to think so, because auditors sure have made a lot of money out of ICFR audits.  Yet, unstated is the fact that 40% of respondents do not believe that the risk of fraudulent misstatement has decreased with SOX. 

Complexity of financial statements -- CAQ would like you to believe that audit committee members think that financial statements are too complicated.  But, the questions don't even begin to address the nature of the complexity, or the sophistication of the respondents as regards financial statements.  And if you still doubt that a self-serving agenda is driving the report, here's the smoking cannon: buried in the back pages (question 17C) is the undiscussed finding that respondents clearly do not feel that GAAP is too complex.  Yet financial statements are too complicated.  Figure that one out!

If you are one of those who believe that the CAQ was created by the powers that be to function as shill for audit firms, then this survey report could be your Exhibit A.  It is also Exhibit A for my point that practitioners with self-serving agendas have good reason to be threatened by the contribution of academics.  But, if truth is the goal, then the participation of academics, trained and paid to apply discipline and rigor to a question, is an asset. 

Bear Stearns: SEC Can't Serve Brokerage Clients and Shareholders Simultaneously

The SEC has been one of the most prominent and well-respected of federal agencies during most of its history.  Strict adherence to a focused mission on disclosure in regards to the regulation of financial reporting by public companies has been its trademark.

Having said that, however, the SEC has been far from pristine in implementing a disclosure-only policy.  Certain actions could be characterized by some as a form of “merit regulation”—some companies may have been unfairly subject to undue scrutiny, and others may have received an undeserved pass.  The SEC has also used its broad powers to make rules requiring added disclosures in some circumstances, and allowing abbreviated disclosures in others.  For example, the SEC has added disclosure requirements to the offering documents of “blank check” companies, and also provided disclosure accommodations to smaller and foreign companies. 

But, if some were to criticize the SEC for merit regulation, cavils of this sort are on the fringes of SEC activity.  And, most important to the criticisms I'm fixin' to deliver, they all relate to the regulatory activities concerning disclosures by companies to the SEC.  But now, an SEC official -- the chair, no less -- has seen fit to make gratuitous disclosures for certain public companies. 

Here's the situation.  Last Tuesday (March 11, 2008), SEC Chair Christopher Cox made the following statement to reporters:  "We have a good deal of comfort about the capital cushions that these firms [the five largest investment banks, which included Bear Stearns] have been on." (http://www.cnbc.com/id/23576630)

At the time, Bear's stock was at $60, a five-year low, and just the day before, Bear issued a press release denying rumors of liquidity problems.  The stock tumbled to $30 early Friday, and over the weekend, JP Morgan struck a deal to buy Bear Stearns for a paltry $2 per share. (For reasons I don't want to cover here, the current market price as I write this is around $5 per share.) 

It's a serious thing that investors may have relied on false and misleading information issued by Bear Stearns, but it is quite another for the SEC to have issued information for Bear Stearns.  (I am trying to making a principled statement here, so that fact that investors who relied on that information got taken to the cleaners is notable, though not the sole basis of my critique.)  Heretofore, a company either complies with the disclosure rules, or it doesn’t; the SEC doesn’t make congratulatory announcements for companies it finds to have been exemplary compliers, disclosers, or what have you.  But if you fail to comply, then that’s when the SEC will tell the world about you; there are thousands of examples of the consistent implementation of this policy.

I imagine that Cox would defend himself on the basis that the SEC is in a curious position with respect to companies like Bear Stearns.  One of the many jobs given to the SEC by Congress is to monitor the “capital adequacy” of broker-dealers.  The objective is to provide a form of protection for the assets of clients who have deposited cash and securities with broker-dealers.  Thus, the SEC is serving two masters, having very different interests in Bear Stearns:  clients and shareholders. 

When Cox chose to speak about Bear Stearns last Tuesday, both groups of Bear Stearns stakeholders were listening, and at least some in each group responded with diametrically opposite courses of action:
       • Some clients of Bear may have been calmed, but too many disregarded Cox’s assurances, took their money and ran;

       • Some investors on the verge of selling their shares had a change of mind -- and some may have even bought stock based on his assurances.   

Cox should have known that he was unavoidably sending a signal of encouragement to jittery investors who were trying to decide whether or not to buy, hold, or sell shares of Bear Stearns.  If SEC history is any guide, it was simply not appropriate for him to have done so. Just as a real estate agent cannot claim to represent parties on both sides of a transaction, the SEC cannot claim to be "the investor's advocate" at the same moment they are functioning as the public relations spokesperson for the investee. It would have been far better to have left the public relations role to other government officials.

The question of how much SEC credibility has been lost is difficult for me to judge.  Assuming this were an isolated instance, it would be significant.  But seen as the latest in a series of questionable actions reflecting the SEC's stance on investor protection, the Bear Stearns case is just more confirming evidence of an altered SEC culture.  I am sad to say that the process of restoring credibility to a once peerless agency cannot begin until there is a new chair. 

FAS 106: Will the SEC Allow GM to Have the Largest Earnings Cookie Jar in History?

---

Note: This post was published about 12 hours prior to publication of Justin Hyde's article on the same topic in the Detroit Free Press.  Justin was the one who brought the topic to my attention, and I made the decision to write this post after a conversation with him.  I thank him for allowing me to go ahead with publication, even though his own article would be appearing later.

---

In an earlier post, I expressed my strong suspicion that top managers at General Motors were utilizing big bath accounting.  By 'big bath', I mean a violation of GAAP that permits delayed recognition of relatively small losses over time, so as to recognize the whole enchilada in some later period.  For some reason that others may wish to ponder, managers prefer the big bath to the accounting equivalent of death by a thousand cuts.  In GM's case, they appear to have improperly delayed as much as $11 billion in writedowns of their deferred tax assets.

Now comes another enormous red flag out of GM's public disclosures.  In fact, the numbers -- in the neighborhood of $50 billion -- make the big bath look like a glass of water.  This new one is of the 'cookie jar' variety: the improper deferral of a gain so as to spread its sweet goodness to the benefit of many subsequent accounting periods.  But, sad to say, this tale has another annoying twist: if GM doesn't get SEC approval for the accounting they are aiming for, they can -- for no other good reason -- opt out of their recent milestone agreement with the United Auto Workers.   

How this Opportunity for Accounting Shenanigans Came to Be

Before I get into the details of the current situation, some background information may help.  GM has an 'OPEB' ('Other Post-Employment Benefit') liability on its balance sheet that is somewhat north of $50B.  It represents the present value of estimated future payments to employees as reimbursement of health care costs during their retirement years. In all, the plans cover about 500,000 current and retired employees. I have read that the expected future payments add about $1,600 to GM's per-vehicle cost, which is about eight times the cost incurred by foreign competitors (who benefit from more generous state-sponsored health care programs).  Note 15 to the financial statements in GM's 2007 10-K indicate that they spent in the neighborhood of $6 billion on retiree health care costs in that year.

Yuck. How did GM let itself get eaten alive by an OPEB in the first place?  The story starts with accounting standards -- or more accurately, the appalling lack thereof.  FAS 106, though significantly flawed, filled a gap in GAAP, but it was birthed only in 1990 -- long after the horses galloped through the open barn door.  My recollection from reading the financial press in the years just preceding is that corporate America was already buried under approximately $1trillion in off-balance sheet liabilities relating to retiree health care costs.  Why did management keep them off-balance sheet?  Because they could.  Why did managers let the liabilities get to be so humongous?  Because they were off-balance sheet.   

Let me explain.  When negotiating with unions, companies could either grant wage rate increases that would affect the bottom line starting at Day 1, or provide deferred compensation that would not hit the income statement for decades.  Such was the case with retiree health care benefits prior to FAS 106.  The "generally accepted" accounting prior to then was "pay as you go."  In other words, you expensed only that portion paid out to employees and their health care providers.  Actual payments (and thus, expenses) at the outset were low because so few of the employees to whom benefits were promised were old enough to begin receiving them.  By the time FAS 106 came to require accrual of benefits as the employees earned them, the unionized rust belt was already awash in unfunded, gold-plated retiree health care plans.  To make matters worse, health care costs looked like they might increase faster than inflation forever.

Back to Now

Late last year, GM and the UAW entered into a compromise ('Settlement Agreement') whereby GM gave its commitment (albeit with an escape clause I shall address anon) to pre-fund, in 2010, its $50 billion accumulated retiree health care obligation.  In exchange, GM would be relieved of any future obligation to make payments, except for funding annual plan shortfalls up to a paltry $165 million per year for the next 20 years.  (The UAW thinks that GM's money should last them 80 years, but that's another story.) 

$165 million? What's up with that?  The numbers I gave you earlier make it abundantly clear that it's but a drop in the bucket compared to the expected plan costs and the number of employees in the plan.  If we assume that expenditures are the current amounts paid by GM and ignore inflation, $165 million amounts to about 10 days worth of coverage. If we further assume that there are about 1 million beneficiaries (retirees plus spouses), that's a safety net of only $165 per beneficiary. That would be like a safety net made of thin-sliced swiss cheese. 

As to the real purpose of the $165 million, it's much akin to a fly on a cow's hindquarter: maybe just enough to get the cow to swish her tail -- or to get the 'right' accounting.  The 'right' accounting for GM is "negative plan amendment" treatment under FAS 106, or else they're gonna pick up their marbles and go home. 

And just what is negative plan amendment accounting?  It's a cookie jar reserve.  Basically, the accounting treatment of transactions of this ilk boil down to three possibilities:

• Settlement: The liability would be taken off the books, and a gain (around $50 billion) would be recorded in 2010 when the settlement occurs.   The GM-UAW agreement looks like a settlement and quacks like a settlement, but FAS 106 (para. 90) defines a settlement as "...a transaction that (a) is an irrevocable action, (b) relieves the employer ... of primary responsibility ... and (c) eliminates significant [emphasis supplied] risks related to the obligation and the assets used to effect the settlement."  Thus, the result of settlement accounting would be no cookie jar: just a blob of earnings that can't be used to juice any earnings-based compensation of top management.
• Negative plan amendment:  Even though a plan amendment immediately affects the calculation of the liability recorded on the balance sheet, FAS 106 requires that it be deferred and recognized over the time that current employees become eligible for retirement (para. 55).  If that amortization period is, say, 20 years, then negative plan amendment accounting creates an earnings cookie jar to be drawn on at the rate of $2.5 billion per year.
• Partial Settlement: GM is insisting that the recognized liability be written down to about $1.5 billion, the present value of a 19-year annuity of $165 million per year.  It is conceivable that one could find that GM is exposed to more risk than that amount, and that, therefore, the liability should be higher. 

Section 21 of the Settlement Agreement (Exhibit 10(m) of the 10-K), is where stated that GM can hold up the agreement if they can't get the liability on their balance sheet down to $1.5 billion.  Both settlement and negative plan amendment accounting will do that, and there is some chance that the Settlement Agreement may qualify for neither.  That's the scenario under which everybody has to sit down and renegotiate.   However, a presentation that GM gave to analysts reveals that the brass ring is negative plan amendment accounting.  That's where the measly $165 million comes in; it's supposed to be just enough to be considered "significant." They want the SEC to say that because of it, settlement accounting is not appropriate, and that accounting as a negative plan amendment is the result.  It's a ridiculous charade, well-hidden by the following 10-K disclosure appearing under the caption "Risk Factors":

"We are relying on the implementation of the Settlement Agreement to make a significant reduction in our OPEB liability. Under certain circumstances, however, it may not be possible to implement the Settlement Agreement. The implementation of the Settlement Agreement is contingent on our securing satisfactory accounting treatment for our obligations to the covered group for retiree medical benefits, which we plan to discuss with the staff of the SEC. If, based on those discussions, we believe that the accounting may be some treatment other than settlement or a substantive negative plan amendment that would be reasonably satisfactory to us, we will attempt to restructure the Settlement Agreement with the UAW to obtain such accounting treatment, but if we cannot accomplish such a restructuring the Settlement Agreement will terminate...."

I have a couple of things to say about this disclosure:

• First, the possibility of not getting the accounting treatment one wants is not a risk factor.  Risk factors have to do with the possibility of real losses; paper losses are just that -- unless, perhaps, recognizing a paper loss has an indirect real effect like tripping a loan covenant.  In fact, the SEC has said as much quite recently, and I wrote about it here.  I admit to not having read the 10-K completely (I do have a life), but I can't see that the accounting treatment has any such indirect effects.  If there were any, that surely is a substantive risk factor, and should have been disclosed. 
• Second, what does Section 21 of the Settlement Agreement and the risk factor disclosure say to providers of capital about the focus of GM's management on the real business of running a car company?  Exactly why is a particular accounting result so darn important that GM is willing to go back to the table with the UAW in order to get it?  Everything else equal, you gotta expect that in a renegotiation GM will end up giving more to the UAW; they will get nothing more in return than a new "economic substance" to run up the SEC's flagpole.

When the ball is in the SEC's court, what will they do with it?  It doesn't appear that anyone at the SEC has lifted a finger to follow up on GM's $11 billion big bath deferred tax asset charge, and I don't expect they will.  My money says the fix is in for this one, too.  The only question is how Chief Accountant Conrad Hewitt is going to fall over himself to give GM the negative plan amendment accounting they crave, resulting in what may be the largest legitimized accounting cookie jar in history. 

I've been blogging about financial reporting for a little over six months now, and so far I haven't had to overly tax my brain to find something to write about once or twice a week.  For whatever reason(s), there are many tales of wealth destruction that begin with a bad accounting rule.  Vast destruction of shareholder wealth ensues by the deliberate actions of managers who realize they can paper over their self-serving behavior with rosy short-term earnings reports.    The cases of retiree health care costs at company's like GM are particularly notable because it takes multiple manager and employee turnovers spanning decades to merely begin the process of exterminating the termites eating away at shareholder wealth and employee job security. 

The GM case is particularly emblematic of corporate governance run amok because the older generations of managers skimmed accounting cream going into questionable deals with unions when more discipline was called for; now, the latest generation is trying to do the same on the back end.  As they go about their business of re-arranging the deck chairs, current management seems to be doing quite well for themselves.  It is even more certain that their scheming progenitors have retired and shielded themselves with ironclad contracts, signed and sealed by board members who effectively serve at the pleasure of the CEO.  Those managers became rich while at the same time bequeathing their legacy of unsustainable labor costs.

IFRS Chaos in France: The Incredible Case of Société Générale

"Breaking the Rules and Admitting It" is the title of Floyd Norris's column describing the accounting by Société Générale for the losses incurred by their rogue trader Jérôme Kerviel; the title is provocative enough, but it's still not adequate to describe this amazing story. Although I am reluctant to come off as a prudish American unfairly criticizing suave and sophisticated French norms, what Société and its auditors have perpetrated would be regarded here as the accounting equivalent of pornography.

I don't aim to re-write Norris's excellent column, who rightly asks what a case like this says about the prospects for IFRS adoption in the U.S.  But, I want to make two additional points.  To tee them up, here's an encapsulation of the sordid tale:

• Société Générale chose to lump Kerviel's 2008 trading losses in 2007's income statement, thus netting the losses of the later year with his gains of the previous year.  There is no disputing that the losses occurred in 2008, yet the company's position is that application of specific IFRS rules (very simply, marking derivatives to market) would, for reasons unstated, result in a failure of the financial statements to present a "true and fair view."      
• You might also be interested to know that the financial statements of French companies are opined on by not just one -- but two -- yes, two -- auditors.    Even by invoking the "true and fair" exception, Société Générale must still be in compliance with IFRS as both E&Y and D&T have concurred.  How could both auditors be wrong?  C'est imposible.   

The first point I want to make is that Société's motives to commit such transparent and ridiculous shenanigans are not clearly apparent from publicly available information.  My unsubstantiated hunch is that it has to do with executive compensation.  For example, could it be that 2007 bonuses have already been determined on same basis that did not have to include the trading losses (maybe based on stock price appreciation)?  Moreover, pushing the losses back to 2007 could have been the best way to clear the decks for 2008 bonuses, which could be based on reported earnings -- since the stock price has already tanked. 

The second point was made by Lynn Turner, former SEC Chief Accountant in a recent email.  The PCAOB and SEC are considering a policy of mutual recognition of audit firms whereby the PCAOB would promise not to inspect foreign auditors opining on financial statements filed with the SEC.  Instead, the U.S. investors would have to settle for the determination of foreign authorities.  Thus, if the French regulators saw nothing wrong with the actions of local auditors -- even operating under the imprimaturs of EY or D&T -- then the PCAOB could not say otherwise. 

Never mind the black eye the Société debacle gives IFRS, this sordid case must surely signal the SEC that mutual recognition would be a step too far; however, I'm not counting on the current SEC leadership to get the message. 

FSP FAS 140-3: Plugging a Hole in GAAP -- Or Another Off-Balance Sheet Financing Gimmick?

I subscribe to a listserv for professors of accounting (http://pacioli.loyola.edu/aecm/) to discuss emerging technologies, pedagogy, and pretty much anything else. One of the recent topics of discussion on the listserv had to do with the impact of accounting complexity on preparing students to become auditors. One participant in the conversation offered up the following quotation from a masters student's paper on the bogus reinsurance transactions between AIG and General Re:

"When companies are involved in these complicated transactions, auditors often don't have the time, training, or knowledge to spot questionable items. When I audited a financial services company during my internship, I didn't really understand their business let alone the documentation that I was reviewing to ensure that controls were operating properly. So much of the work we conducted was based on mimicking the prior year's work papers that even after levels of review I believe fraud could have easily slipped by." [italics supplied]

Coincidentally, FASB Staff Position (FSP)  FAS140-3, Accounting for Transfers of Financial Assets and Repurchase Financing Transactions, has been recently finalized; this student's lament came to my mind while I was attempting to decipher the new accounting rule.

In order to begin to explain the FSP, you need to know that FAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities, contains criteria that restrict "sale accounting" on transferred financial assets when there is a concurrent purchase agreement.  Consequently, “repurchase agreements” (repos) may be subject to "loan accounting" instead of sale accounting. The difference in accounting treatments is as follows: under sale accounting, the asset comes off the balance sheet and is replaced by the proceeds from sale; under loan accounting, the asset stays on the balance sheet, so the credit offset to recognition of the proceeds is to debt.  So most significantly, sale accounting is off-balance sheeting financing, and loan accounting is on-balance sheet financing. 

To the financial engineer attempting to defeat the best efforts of investors and/or regulators of financial institutions, loan accounting is a bad thing, and sale accounting is good.  So, one important challenge for them is how to fabricate an 'arrangement' that gets under FAS 140's fence to permit sale accounting.  This appears to have been invented by a mortgage REIT through a variation on the repo (essentially a round trip for the asset) whereby the financial instrument now makes one more trip back to the original transferee. If you're confused, this picture may help: 

The vanilla repo is essentially a collateralized loan, with the legal title to the collateral held by the lender during the term of the loan.  Since the asset makes three trips under the FSP FAS140-3 version, the argument is being made that the initial transfer is not part of a repo--and that the second and third trips constitutes a repo in reverse.  The accounting argument is that if the initial transfer appears to be economically de-linked from the subsequent two transfers, then the accounting should be de-linked as well. The FSP is needed because FAS 140 does not directly address this point, and it provides that the first transaction could be eligible for sale accounting--if the criteria in FAS 140 for sale accounting is also met.

Thus, the FSP provides "guidance" (i.e., the hoops the lawyers and financial engineers have to jump through) for determining whether an initial transfer of a financial asset and a "repurchase financing" (the last two transfers) can be de-linked.  The first hoop is the most important, and the one that will cause accountants, both young and old, to have acid reflux:  does the arrangement have a valid business purpose?

A valid business purpose?  Ha!   Prior to SEC rules restricting revenue recognition for bill and hold sales, did these arrangements have a valid business purpose?  Maybe one percent of them.  The other 99 percent were mere schemes concocted to end-run pesky revenue recognition criteria.  I can't vouch for this, but my strong suspicion is that the arrangement subject to FSP 140-3 springs from the same primeval instincts as the bill and hold sale.  In other words, the presumption of a "valid business purpose" would be a fiction 99 percent of the time. No matter what the bells and whistles of the arrangement are (if you can understand them from reading the contracts), the motivation is the accounting result.

Never mind the judgment exercised by the FASB in publishing what amounts to a user's manual for yet another off-balance sheet scheme, one must ask whether the FASB is tone deaf or indifferent to the recently inflamed ire of investors and politicians with off-balance sheet accounting.  And, while financial services are the targeted beneficiary of FASB largess, you never know when some Fastow-type CFO is going to apply it by "analogy" to their own nefarious machinations involving power plants, energy contracts, leases or what have you. 

So, good luck dear accounting students; here's hoping your first assignment is not to audit a financial services company, or some other innocent looking dog that bites like the big, bad wolf.

FASB Governance: Damn the Feedback, Full Speed Ahead to IFRS!

The Financial Accounting Foundation (FAF), the body that governs the FASB, has issued a press release announcing the results of their one meeting to consider the feedback on their proposals to change the way the FASB operates.  To reiterate from a prior post (though somewhat less gentle this time!) the proposing document was a model of obfuscation.  It was clear from the outset that FAF wasn't at all interested in knowing what anyone else had to say about reducing the size of the FASB, voting rules, or how the FASB would set its agenda.  Any discussion of past problems, current needs, etc. were vague (more accurately, not mentioned) in a thinly veiled attempt to frustrate and limit comments.  It certainly frustrated me; I abandoned the effort as soon as I realized that anything I wrote could, by design, amount to no more than the equivalent of shooting at a flea with an elephant gun while blindfolded. 

So, predictably -- and despite the clear protests of Financial Executives International, the CFA Institute and numerous former board members -- all the proposals passed muster with flying colors.  One of my readers, who shall remain anonymous, wrote to me soon after he heard the FAF news to tell me that he had spoken to a former FASB project manager about it, and the only comment he had was "unbelievable."   

Would You Trust the Future of U.S. GAAP to These Guys?

The rat I had been smelling for weeks walked right into the middle of the room during the FAF press conference in which its members rationalized their actions with comments to the effect that requiring new board members to all have knowledge of "investing" (whatever that means) will assure that the entire board will give adequate consideration to investor needs.  Right.  Guess who will be excluded: someone to replace Donald Young, the current investor representative, whose term expires this year; and you can forget about any more academics, lest some pesky dissenter asks too many uncomfortable questions that could slow down the IFRS convergence train. 

And, what kind of convergence are we going to get under the new FASB?  If facilitating a constructive and stable convergence with IFRS is the real goal, why is it appropriate for the IASB to have fourteen members, and now the FASB only five?   No good answer.  Why is it appropriate for the IASB to require a super-majority vote of nine members to adopt a new rule, and the FASB only a simple majority of three -- the FASB chair, who now sets the agenda, plus two handpicked shills?  No good answer.  What evidence is there that it will be difficult to find new board members who are sufficiently knowledgeable of IFRS to hit the ground running when they are appointed?  LOL.

It's obvious to me that the real goal is not a convergence to benefit U.S. investors; for that would require careful study, thinking and time.  The real goal is quick-and-dirty convergence -- so that the big audit firms can get on with the business of charging large fees for the accounting changeovers while at the same time lowering their long-term audit risk -- and so that their clients can manage earnings with less fear of interference by the SEC (see my earlier posts here and here for the reasons why this is so, and why it is harmful to investors).

Speaking of the SEC, What's Their Take?

By the way, FASB's pronouncements are rules for public companies to follow whilst the SEC so deigns. One would think, therefore, that the SEC would have taken more than a passing interest in changes to how the FASB is organized and governed.  Yet, I haven't noticed a peep out of Conrad Hewitt, the SEC's chief accountant.  Given his recent track record, I can't say I'm surprised.  All I can say is that I'm glad that I served in the Office of the Chief Accountant in a different era.  Under the current administration the SEC has become more the captain of the public company cheerleaders and less the watchdog of investors. 

It's a shame.   

FAS 52: Another Goodwill Charade, and IFRS Convergence To Boot

---

Would you like to learn more about FAS 52? 
Click here for a sample in-house training agenda!

---

In a recent post, I argued that goodwill arising from a business combination was just a random number; therefore, any attempt to measure impairment amounted to nothing more than a costly charade.  By coincidence, I recently had an inquiry from a client about the accounting for goodwill at foreign subsidiaries per FAS 52.  Thinking about it for my client also reminded me of yet another sordid tale of accounting convergence for its own sake. 

The General Problem of Goodwill Arising from Foreign Subs under FAS 52

By way of background, FAS 52 requires that assets of a foreign subsidiary with carrying amounts based on historic costs (e.g., plant and equipment) be translated into the reporting currency (e.g., dollars) at the exchange rate existing on the balance sheet date (e.g., the 'current rate).  As I have noted in an earlier post, multiplying historic costs by current exchange rates is the equivalent of multiplying apples and rocks -- with the inevitable result being a random number. 

What about goodwill arising from the acquisition of a foreign subsidiary?  As I am about to show, the choices arising out of a slavish application of the general approach of FAS 52 is so absurd that the FASB buried its own decision deep in an Appendix.  Be that as it may, the specific question is whether goodwill should be measured in dollars, or measured in the currency that is used to measure all of the other assets and liabilities of the subsidiary and translated into dollars.  The implications are the following:

1. If the foreign currency is the answer, then goodwill will be translated to dollars at each balance sheet using the current exchange rate.  Exchange rate movements will affect the carrying amount of goodwill expressed in dollars, which will in turn affect consolidated shareholders' equity through other comprehensive income (the so-called 'translation adjustment'). 
2. If goodwill is measured in dollars from the outset it will remain at a constant dollar amount over time, unless it becomes impaired per the FAS 142 charade.   

From an investor's viewpoint, which treatment of goodwill is preferable? Measuring in a foreign currency and translating with current exchange rates (the first choice, above) adds another information-less element to goodwill measurement, confounding even further any potential to glean something relevant out of the translation adjustment.  Therefore, measurement in dollars (the second choice) would be the lesser of two evils. 

Which answer did the FASB pick?  Hint: look for the answer that creates a consistent set of rules, irrespective of whether the rules themselves make any sense.  Yep, FAS 52, para. 101 requires goodwill measurement in the foreign currency.  The only conceivable reason must be that it is consistent with the treatment of other historic-cost-based assets of the foreign subsidiary.   

Unintended Consequences

That brings me to the question my client asked, which goes something like this:

The functional currency of Company A is the U.S. dollar.  Company A acquires 100% of the outstanding shares of Company B, for which the dollar is also its functional currency.  However, Company B has two foreign subsidiaries, C and D, whose functional currencies are their respective local currencies.  Given the requirement of paragraph 101 of FAS 52, must a portion of the goodwill recognized from A's purchase of B be attributed to C and D? 

It would seem that the fact pattern described above is not uncommon.  Yet, I could not find even a glimmer of insight in the official GAAP literature that would acknowledge that the problem even exists. So this is how my own thinking goes:

• Given that the only purpose of paragraph 101 would appear to be consistent with the accounting for other assets, one would think that a reasonable allocation of goodwill would be intended.  Take the extreme example where the U.S. operations of the acquired company might be insignificant: failure to allocate goodwill among the subsidiaries would result in a significant inconsistency, and perhaps even, an opportunity for manipulation.
• FAS 142, charade that it is, does require a rigorous apportionment of goodwill among reporting units for the purposes of determining whether goodwill is impaired.  A reasonable approach to allocating goodwill to foreign subsidiaries might be similar to the reporting unit approach of FAS 142.   

However, to my surprise, the few inquiries I have made of practitioners with experience in the area are unanimous in the view that, in practice, goodwill would not allocated below the intermediate parent -- in this case, Company B.  Why might practitioners take that view?  Because no rule prevents them from doing otherwise; and because it benefits them to reduce the volatility caused by translating goodwill from a foreign currency to the reporting currency.  In fairness, and as I have noted above, even though what appears to be broad practice may result in inconsistencies, it is arguably better accounting -- or rather less bad -- than results from a rote extrapolation of the extant rules (which is the most I can say of my own reasoning).

The International Convergence Connection

As I have pointed out elsewhere (interest cost capitalization), some changes to IFRS are made for the sake of convergence, with well-reasoned standards thrown on the junk heap for the sake of convergence with U.S. GAAP and the prospect of IASB financial reporting hegemony. The goodwill provisions of IAS 21, the IFRS counterpart to FAS 52, is another case in point.  At one time, IAS 21 allowed either of the approaches we have discussed for goodwill measurement.  But as part of an omnibus project to eliminate alternatives in numerous standards (brought on by the 2005 adoption of IFRS by the EU), the IASB eliminated the option to measure goodwill in the reporting currency, making it the same as FAS 52.  Again, the only conceivable motivation appears to be convergence for convergence's sake. 

I imagine that the progenitors of the original IAS 21 were thinking that at least part of goodwill arises from synergies between a parent that 'thinks' in its reporting currency and a subsidiary that 'thinks' in a foreign currency.  Thus, the source of the goodwill is not strictly foreign or domestic; so, who is to say in which currency goodwill should be measured?  Evidently a race for convergence trumps reason and reasonableness.