The Accounting Onion

FAS 158: Pension Accounting Crawls its Way Towards Reality

The FASB has belatedly, and only half-way closed the proverbial barn door on misleading pension accounting in FAS 158. In re-measuring pension assets and liabilities on the balance sheet, Paragraph 16a of SFAS 158 requires that the effect on equity of the transition to FAS 158 be reflected as an adjustment of the ending balance of accumulated other comprehensive income (AOCI). This would have taken effect on December 31, 2006 for calendar year-end companies.

Apparently, however, a significant number of companies (I wish I knew how many) have not fully complied with the FAS 158 transition rules--by incorrectly reporting the adjustment as a component of comprehensive income for 2006.

Of course, the skeptic that I am wants to know whether 'errors' were commited mostly by companies that were able to show positive amounts of other comprehensive income (OCI).  If anyone has any data on this, please let me know!

In any case, the SEC Staff has chosen to turn a blind eye toward any possible efforts at manipulation.  They have taken the position that a quantitatively significant misapplication of the transition provisions of FAS 158 need not be considered material if: (1) there are no qualitative indications of materiality (see SAB 99 for guidance in determining qualitative materiality), and (2) the transition adjustment component of comprehensive income had been clearly disclosed. 

You can find a report of the SEC Staff position online in the form of an AICPA publication, Center for Audit Quality Alert #2007-30.

Here Comes the Rant

If pension accounting (principally FAS 87) were not such a complicated mess, obviously designed to appease the country's largest employers at the time (and incidentally create jobs for accountants and their actuary cousins), how many more employees would now be receiving their full pension benefits?  How much less dire would be the status of the Pension Benefits Guarantee Corporation (PBGC)?  One thing I do know is that four FASB members voted yea, and three voted nay.  If only one more member had a backbone, how much wealth destruction would have been prevented?

FAS 158 is the supposed culmination of the first phase of a project to move toward more straightforward, transparent and complete recognition of assets and liabilities related to pension plans and other postretirement benefits.  Pension accounting should be as simple as this:

1. Calculate the net pension liability/asset as the difference between the fair value of plan assets and the actuarially determined projected benefit obligation.  This number goes on the balance sheet.
2. Report the change in the net pension liability/asset on the income statement.

Although not perfect (remember, dear readers, that perfection is the enemy of the good), the first step was accomplished in FAS 158.  What is taking the FASB so long to require the second step?  C'mon folks, show us that you have a backbone!

AS 5: The Latest Chapter in the SOX 404 Saga

Following an extended comment period, Auditing Standard No. 5, which supersedes AS 2, was approved by the SEC on July 25, 2007.  Now that another chapter in the regulatory saga of SOX 404 is complete, it is time once again to take stock of what has (and not) been accomplished by Congress, the SEC and the PCAOB.

Frederick Lipman, founder and president of the Association of Audit Committee Members, Inc. (AACMI) trenchantly observed as follows in a recent communication to its members (Fred is also the leader of the securities law practice at Blank Rome LLP):

“The corporate corruption scandals which motivated the Sarbanes-Oxley Act of 2002 were the result of fraud by CEOs and CFOs and it is unclear how Section 404 mitigates this risk, since internal controls can be overridden by the CEO or the CFO.  The SEC has conceded as much in  SEC Release No. 33-8810 (June 27, 2007) which contains the following revealing comment: 

‘ICFR cannot provide absolute assurance due to its inherent limitations; it is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures.  ICFR also can be circumvented by collusion or improper management override.  Because of such limitations, ICFR cannot prevent or detect all misstatements, whether unintentional errors or fraud.  However, these inherent limitations are known features of the financial reporting process, therefore, it is possible to design into the process safeguards to reduce, though not eliminate, this risk.’ [Emphasis supplied by Lipman] 

It therefore remains questionable whether any of the corporate corruption scandals would have been avoided by the costly internal controls mandated by the regulators.  The regulators are to be congratulated, however, for at least attempting to mitigate some of these costs by adopting Auditing Standard No. 5.”

I have long argued that SOX 404 was flawed, and that investors would have been better served by requirements for mandatory audit firm (as opposed to partner as provided in SOX).  I'll explain why I feel that way in a subsequent post.  I'll also be commenting on the new definitions of 'material weakness' and 'significant deficiency' as used in both AS 5 and SEC rules.

Other Things You Were Dying to Know about AS 5

The new standard is effective for audits of internal control over financial reporting (ICFR) required by Section 404(b) of SOX for fiscal years ending on or after November 15, 2007.  Earlier adoption is permitted, but auditors who elect to comply with AS 5 before its effective date must also comply at the same time with PCAOB Rule 3525, and other PCAOB standards as amended by Auditing Standard No. 5.  Auditors who do not elect to comply with AS 5 before its effective date must nonetheless use the kinder and gentler definition of "material weakness" contained in AS 5.

PCAOB Rule 3525, relating to auditor independence, requires auditors to comply with specific documentation and other procedures when requesting audit committee pre-approval of internal control-related services.  Similar requirements were contained in AS 2, and they parallel the auditor’s responsibilities in seeking pre-approval to perform tax services for an audit client under PCAOB Rule 3524.

EITF 07-03: Which Part of 'Nonrefundable' Doesn't EITF Understand?

EITF Consensus 07-03, Accounting for Nonrefundable Advance Payments for Goods or Services to Be Used in Future Research and Development Activities, is very straightforward and basic; so much so that it might require less than one class period of Accounting 101 to discuss thoroughly. 

Here is a typical fact pattern: Entity A outsources R&D activities to Entity B, who requires a nonrefundable advance payment.  Should Entity A capitalize or expense the advance payment?  Proponents of the asset/liability view (i.e., expense measurement based only on changes in assets and liabilities) would support immediate expensing; proponents of the competing revenue/expense view (i.e., 'matching') would capitalize the expenditure and subsequently transfer it to expense as services are performed. 

The SEC and FASB have stated they are committed to the asset/liability approach to accounting standard setting, at minimum implying strong resistance to creation of new categories of deferred costs. The policy was officially established in 2003, as the SEC fulfilled its responsibilities under the Sarbanes-Oxley Act to report on the possibility of implementing principles-based accounting in the U.S. In its report, the SEC took the position that the revenue/expense view would be inappropriate in an objectives-oriented regime, and further stated that the FASB should maintain the asset/liability view in continuing its move to an objectives-oriented setting regime.  The FASB published a response, which agreed with the SEC study on this point. 

In a nutshell, matching had been dead for over a decade, and the SEC's SOX report should have been the last nail in the coffin.  Or so it seemed, as the EITF reached a consensus that nonrefundable advance payments for future R&D activities should be initially capitalized and subsequently transferred to expense as the goods are delivered, or services performed.  As justification, the EITF claims, without citing a source, that customers who agree to nonrefundable advance payments nonetheless have a legal right to receive a refund in the event of nonperformance.  Huh?  Are they saying that 'nonrefundable' means 'refundable'!  You say refundable, I say nonrefundable; let's call the whole thing off. 

One can only guess what forces were at play on the EITF (my money is on drug companies) as Issue 07-03 was deliberated.  As if it weren't obvious enough that the fix was in, a telltale sign is provided by the statement that the Consensus may not be applied by analogy to facts and circumstances outside of its narrow scope. 

PS - For those of you numerologist/accountants out there, you may be interested to note that my birthday is July 3rd.  Some dark force surely decreed that I should write about EITF 07-03.