The Accounting Onion

Sarbanes-Oxley and Smaller Reporting Companies: There is a Better Way

I apologize for the long interval between this and my last posting – especially to those of you who have privately thanked me for material just boring enough, and long enough, to induce a good night's sleep. Tax blogs, I am told, are much too potent unless one is planning to spend an entire holiday weekend in bed.

This long-awaited naturopathic sleep remedy is based on Floyd Norris' recent critique of efforts to roll back some of the provisions of the Sarbanes-Oxley Act. Roughly in descending order of offensiveness, we have movements afoot to:

1. Place the FASB under the supervision of a systemic risk agency, which would in turn be heavily influenced by the banking interests who still blame fair value accounting for the financial crisis;
2. Rescind for companies that have a public float of less than $750 million the requirement that an auditor attest to management's assertions regarding the effectiveness of internal controls (S-OX 404(b));
3. Challenge the constitutional legitimacy of the PCAOB; and
4. A House of Representatives committee vote to exempt the 6,000 'smaller reporting companies' (i.e., market cap. < $75 million) from complying with S-OX 404(b).

If I had been writing a blog back in 2002 as S-OX was being rushed to a vote in spasms and fits of self-righteous bipartisanship (did blogs actually exist?), I would have predicted something like this would be happening about now. Having nothing whatsoever to do with the philosophical leanings of the party in the majority, such is the formula by which U.S. political dramas are scripted. Declarations of war (figuratively and literally) through zealous and hastily enacted statutes are inevitably followed within just a few years by reversals to more moderate positions. Regarding the securities laws (and holding the frightening prospect of IFRS adoption aside), we are clearly in a period of moderation, albeit more misguided than usual.

While I echo Norris' sentiments on the first three items, I had only a few weeks ago expressed my glee that requiring smaller public companies to comply with S-OX 404(b) might soon be trashed. I had previously observed that S-OX 404(b) attestations have appeared to devolve into a go-through-the-motions exercise. Those suspicions are validated to some extent by a recent ruling against defendant Deloitte on a motion for summary judgment in a lawsuit alleging that Deloitte failed to adequately report on internal control deficiencies at WAMU. Jim Peterson of the Re: Balance blog avidly follows the solvency tightrope that each of the Big Four is walking as they try to fend off litigation arising out of 'traditional' public company audits. His view is that auditors should walk away from S-OX 404(b) work while they are still ahead. 

There Must be a Better Way

Even though S-OX could have, and should have, been more tightly focused on measures to prevent another Enron or WorldCom from happening, something was missing in the securities laws for providing reasonable assurance that management public companies, both large and small, are taking their financial reporting responsibilities seriously enough. I just don't agree that S-OX 404(b) was the right way to go about it.  Notwithstanding other merits of a financial reporting regulation, a windfall to gatekeepers, especially those sharing the blame for a lack of confidence in the system, is a reason for any reasonable person to be suspicious. 

Given that change is in the offing, now may be the time to bring back my old war horse, mandatory audit firm rotation. The resistance to mandatory audit firm rotation in the wake of Enron and WorldCom came from the AICPA, which couldn't bear the thought of auditors being audited by other auditors. Their main stated argument had been that switching costs would be too high, as audit efficiencies in the client's environment take a few years to be realized.

Even accepting the AICPA's excuse, which I absolutely do not, it is a fact that the vast majority of audits of smaller firms are much more straightforward. That should mean that the successor auditors can, relatively speaking, take over from predecessors without breaking stride. I would like to suggest to Mary Schapiro that, instead of pushing against the bipartisan will of Congress to let smaller reporting companies out of S-OX 404(b), she should promote mandatory audit firm rotation. There is nothing to suggest that it will impose anywhere near the scale of costs engendered by S-OX 404. With little at risk, it could actually transform audits from a make-the-client-happy exercise to one that moves the U.S. toward the forefront of global capital markets just in terms of basic integrity.

Let's pick 2,000 smaller reporting companies at random and require that they switch auditors within a year; another 2,000 next year, and 2,000 the year after that. If done right, there should be a wealth of data for the SEC and academics alike to analyze. For the next time we take a whirl on the regulate/moderate merry-go-round, we will at least have some hard evidence to take along.

(By the way, I recommend that you try Kevin LaCroix's D&O Diary blog for excellent non-technical summaries of current developments in securities litigation.)

And Our IFRS Survey Says…

This is the first of a series to discuss the results of our IFRS opinion survey. The idea for a survey originated with yours truly, and I was moved to do so (more like propellled with outrage) by the ersatz pro-IFRS "research" coming out of the Big Four and the AICPA propaganda machines. I also decided to seek a collaborator from the ranks of academia through the AECM listserv, and I consider myself very fortunate that Pat Walters, herself an IFRS proponent, volunteered to work with me. Pat's association with this effort should lend, at the absolute minimum, a semblance of balance; which is, ironically, completely absent from published views of the Big Four and their shills.

But, thankfully, I can report that not all CPAs have behaved like pigs at the trough. We owe a huge debt of gratitude to Gaylen Hansen, who has provided us with a clear-eyed compilation of the response letters to the SEC's Roadmap proposal; and to Grant Thornton for their survey, which was published as we were conducting ours. GT asked a question of import ("Ideally, who should set U.S. accounting standards?") properly, and received proper responses from CFOs and senior comptrollers in return. GT reports that only 18% of more than 800 respondents from public companies are of the opinion that the IASB should be setting accounting standards for U.S. companies.

Full Disclosure and Caveats

We received a total of 289 responses. We can't beat GT on sheer number of responses, but we did ask a broader set of questions regarding the perceived relationships between IFRS and GAAP: (1) quality differences; (2) costs and benefits of IFRS adoption; and (3) how the SEC should act on its Roadmap proposal. You can view all of our response data in a spreadsheet format here, and the text of the online questionnaire here. Twenty-seven responses came from non-U.S. residents and 13 from students. Our analysis excludes these two groups, and the tabulation at the end of this post breaks down the respondents we analyzed by all of their occupations.

Before we proceed to the major takeaways from our survey, two further caveats are in order.

First, we sure were hoping to generate a larger number of responses. GT excepted though, our level of participation is well within the range of other "studies" conducted by the IFRS proponents, including the number of comment letters received by the SEC in response to the Cox-instigated Roadmap Proposal. We left our survey open for three weeks; the SEC's comment period extended for months.  

Second, one should always take with a grain of salt unsolicited responses, as opposed to a random sample. But, no study that we are aware of has employed a more open self-selection process than ours. For example, I was solicited for Deloitte's survey apparently because I subscribed to one of their IFRS information services; if that was Deloitte's only method for soliciting responses, the self-selection bias therefrom is self-evident.

The Major Takeaways from Our Survey

As with GT, we asked for opinions regarding IFRS adoption; and our results were very similar to theirs:

My initial interpretation was that 71% of respondents do not agree with the proposition that IFRS should replace U.S. GAAP. Pat pointed out that this may be somewhat of an overstatement—since we don't know why 16% of respondents "neither agree nor disagree." Those respondents, according to Pat, could very well be indifferent to the prospect of IFRS adoption. My own take on that is: if one took the trouble to take the survey and to answer the question, then indifference would not be the most likely sentiment being expressed. Nevertheless, Pat and I agree to this interpretation:  respondents who disagreed with the proposition outnumbered those who agreed by a margin of about 5:3. Anyway you look at it, especially in light of GT's results, it should give the SEC pause before proposing to supplant the FASB with the IASB.  That's as mildly as I can put it.

When I took a closer look at the answers to this question, I was not surprised to see that the frequency distribution of responses from Fortune 500 companies and the Big Four appeared to be negatively correlated with all of the other occupations. To evaluate their impact on the full results, I decided to disaggregate each question by three subgroups: (1) Fortune 500 + Big 4; (2) academics; and (3) everyone else. The chart below repeats the results from above and adds these subgroups:

 

See that tall blue bar on the left? That's Big 4 and Fortune 500 money talking. Notice also that academics (the ascetic purists J), are the least inclined to adopt IFRS (as indicated by the short green bar on the left).

Given these results, it should come as no surprise that a significant majority of respondents do not believe that the benefits to investors of IFRS adoption would exceed the costs of conversion:

77% of all US respondents do not believe that benefits to investors will exceed the cost of conversion. Indeed, although a majority of the Fortune 500 accountants and Big Four auditors believe that the SEC should adopt IFRS, only 44% believe that the benefits to investors would exceed the cost of adoption. Figure that one out.

The bottom-line question we asked pertain to how the US should approach adoption of, or convergence, to IFRS:

These results are, admittedly, somewhat difficult to interpret with precision, but they clearly indicate that few respondents would like to see IFRS adopted before 2014. Moreover, 54% of respondents (including the Fortune 500 and Big 4) would either prefer not to adopt IFRS, or to adopt it starting with 2020 at the earliest. Although an in-depth analysis of the "other" category of responses was not undertaken, my brief analysis strongly indicates that a comfortable majority of the "other" responses more closely resemble those who stated a specific preference to either delay in IFRS adoption beyond 2020, or to abandon IFRS altogether.  If you don't believe me, you can look at the data for yourself.

And, as one might expect, the Fortune 500 accountants and Big Four auditors were strongly in favor of relatively fast-paced IFRS adoption, although it must be said that less than 10% favored adoption by 2012-2013. But, take those folks out, and you have even less interest among respondents for adopting IFRS anytime soon … or ever.

Act II

Thus far, I have discussed the results of only three of the ten questions that we asked about IFRS vs. U.S. GAAP. I promise you, more drama is to come. Also, Pat has agreed to write a guest post with the working title, "How the Survey Result Informs an IFRS Proponent." I'm sincerely looking forward to that.

The Speak-No-Evil FASB

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Haven't Taken Our IFRS Opinion Survey?
We Need Your Input!! 
Click here to answer 12 brief questions.

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My previous post lambasted the FASB for shilling the SEC's whacky proposal to measure the year-end value of oil and gas reserves at average prices for the year – instead of the year-end price. Since then, I had two follow-on thoughts; the first one I'll mention is not related to the cheeky title of today's post, but it leads into the one that is.

A More Reasonable Way to 'Modernize' Oil and Gas Disclosures

A week ago, I forgot to mention that there really is a reasonable way to enhance the measurements of year-end values of oil and gas reserves, the ostensible goal of the SEC's recent actions.   But, it has nothing at all in common with the SEC/FASB approach of using averages.  What I have in mind is 'sensitivity analysis.'

Investors can use information about the current value of reserves today, but they also can use information concerning risk of changes in value. Financial reporting rarely reports that kind of information, but there have been movements in that direction of late, and by the SEC no less. Most prominently, Item 305 of Regulation S-K requires quantitative measures of market risk sensitive financial instruments, which often takes the form of some version of a sensitivty analysis.  In addition, Financial Reporting Release No. 60, urges companies to provide a sensitivity analysis covering assumptions underlying critical accounting policies.

So why not provide a sensitivity analysis regarding the value of oil and gas reserves? It doesn't have to be complicated, and the resulting disclosure could be as clear and simple as the following:

Using end-of-year energy prices, the present value of proven reserves is $100 million as of December 31, 20x0. Energy prices during the year ranged from 80 to 130 percent of the year-end prices. If the lowest (highest) energy prices during the year were substituted in our year-end present value calcultions, the lower end of the range would result in a $50 million valuation, and the higher end of the range would result in a $130 million valuation. The range of valuations is not proportional to the range of prices for the following reasons: [would be listed here.]

Sensitivity analysis of valuations can always be informative, but particularly so in the extractive industries. A significant portion of the value of the investment in a project can be traced to 'real options'; e.g., to invest in additional development if prices rise, or to shut down operations until such time as commodity prices recover. In fact, in the three decades since the SEC came out with its original version of oil and gas disclosures, the topic of 'real options' has gone from esoteric to an essential component of any capital budgeting decision by the larger players in the extractive industries. By the same token, investors are in a better position to value options (especially those that are not recognized on the balance sheet) if they can more reliably estimate the volatility of a project's value.

Covering Ears, Eyes and Mouths

Maybe you like my suggestion to add sensitivity analysis to the present value of reserves disclosures, or maybe you don't. Whatever your opinion, you should definitely be incredulous that the FASB appears unwilling to give any alternative to the SEC's hatchet job so much as lip service.

Now that the ball is in the FASB's court, one must ask whether all of them have truly put their brains in neutral, or whether they have even considered alternatives to the SEC's approach.  If they have chosen to put their brains in gear, we certainly can't tell from their proposing document or any other public comments. At least at the SEC, dissenting board members give speeches that reveal their own preferences and reasoning. It appears that FASB members, perhaps as a matter of basic economic incentives (i.e., money), don't dare to do the same. Based on the way the last investor representative on the board was treated, it's pretty safe to assume that, if you are not a go-with-the-flow sort of chap, chances of getting your $500,000/year position renewed for a second five-year term are slim to none.

Here's my prediction as to what is going to happen with the ED. The Board is going to vote 3 -2 in favor of measuring the value of proven reserves at average prices. Two board members, Linsmeier and Siegel, are going to furnish compelling dissents, and maybe another financial columnist will celebrate the dynamic duo for the strength of character they displayed while others around them were busy shilling. But in the final analysis, after-the-fact minority dissents will have no effect on anything real or important. As my father too-often said, "If all you have to stand on are your principles, then you may as well remain seated."

Yes, minutes of open meetings report board members' comments leading up to exposure documents, but who reads them? I might if I were to have trouble falling asleep at night. Why aren't formal dissents registered in exposure drafts? Why don't board members, as SEC commissioners often do, provide their individual views when they go around making speeches? For true 'due process' to occur, we need more open public debate on the issues. Commenters on FASB proposals need to have some idea of the level of consensus within the board.

I suspect that every single FASB member thinks that measuring the value of proven reserves by average, instead of current, prices is a significant step in the opposite direction from quality financial reporting. So, perhaps I am being unfair in calling on only Tom Linsmeier and Marc Siegel to carry the flag of reason and investors' interests. But, no good deed goes unpunished. That's what they deserve for taking principled stands in the past – even if, thus far, they have amounted to little more than empty gestures.

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Haven't Taken Our IFRS Opinion Survey?
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Click here to answer 12 brief questions.

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FASB Proposed Changes to Oil and Gas Disclosures: A Crude Sham

Before I discuss the sordid details of a recent FASB proposal, please take a moment to read this hypothetical: 

What if the FASB were to issue a proposal to require companies holding marketable equity securities of oil companies to calculate and report their investment as the number of shares owned multipled by the average share price over the past year.  The average share price would be calculated from the closing share prices on the first day of each of the past twelve months.  (In other words, changes to share prices over the last month of the year would not be counted.)

Assume that the FASB issued its proposal to respond to concerns of financial statement issuers with significant holdings of oil and gas shares that reporting full year-to-year fluctuations in investment values would not constitute "meaningful" information to investors. 

Incredible?  Yes.  Impossible?  No. As I am about to describe, something very close to my hypothetical scenario has left the station and is unlikely to be stopped before pooping on the financial statements of oil and gas producers.

In an earlier post, I imparted the common-sense view that the historical-cost based financial statements of oil and gas producers bear almost no relation to a firm's value; because, the historic cost of a producing field, however measured, bears no relation to the value of that field.  There are a number of reasons for this, having to do with the luck of the draw or the price for the output that will be obtained from extracting the field's reserves over ensuing decades. To make a long story short, that's why disclosures are critical in the oil and gas industry. 

In particular, two disclosures are critical, and it should come as no surprise that oil and gas companies go to great lengths to 'manage' them: (1) the quantities of oil and gas that can't be seen, but are estimated to be in the ground; and (2) a standarized calculation of the amount that the "proved" portion of those in-the-ground reserves are worth.  The former is technically an SEC-required disclosure, and the latter, which I will refer to as the  "present value of proved reserves" is to be found in the FASB's rules.

"Modernizing" Oil and Gas Disclosures

In December of last year, the SEC issued a final rulemaking release to update the three-decades-old oil and gas disclosure requirements for current practices and changes in technology.  As I described in two previous posts (here and here), numerous important and overdue changes to the disclosure rules were made.  But there were also numerous sops to the oil and gas industry.  Among the biggest gifts was the SEC's statement of intention to get the FASB to muddy up oil and gas valuations -- pretty much in the manner I described in my hypothetical scenario -- by substituting a crude estimation of averages prices for year-end energy prices. The only differences from my scenario are that the measurements are made in disclosures of reserve values, and that they affect the investee's financial reporting (as opposed to the investor's in my hypothetical). 

Just as they were commanded, the FASB did indeed issue with great alacrity its own proposal to alter the net present value calculation along the dubious lines specified by the SEC.  The FASB's "basis for conclusions"?  Here ya go: 

"After taking into consideration more than 70 comment letters from financial statement users, preparers, auditors and other constitutents, the SEC refined its proosed rule on oil and gas reporting and issued the Final Rule on December 31, 2008."

There is some brief discussion of other specifics, but with respect to the change in measuring the net present value of proved reserves, there is absolutely nothing more.   And even what is provided is grossly misleading.  Of the 70 comment letters, virtually all came from oil and gas producers, lawyers representing oil and gas producers, engineers working for oil and gas producers, auditors whose largest clients are oil and gas producers, and consultants whose clients are oil and gas producers. 

I could not find a single comment from an investor (even notice the weasel term "financial statement users" in the above quotation) among the list of comment letters posted on the SEC's website.  A more accurate description from the FASB of their thinking (or lack thereof) would have been something like this: "The Cox-led SEC did their thing, and that's good enough fer us. Cuz they're the SEC.  We got nuthin else to say about 'due process' or any other process."

But in case you are wondering what the FASB is proposing to swallow -- hook, line and sinker -- here it is from the SEC's proposing release:

"Some believed that reliance on a single-day spot price is subject to significant volatility and results in frequent adjustment of reserves. [footnote omitted] These commenters expressed the view that variations in single-day prices provide temporary alterations in reserve quantities that are not meaningful or may lead investors to incorrect conclusions, do not represent the general price trend, and do not provide a meaningful basis for determination of reserve or enterprise value." [italics supplied by me]

Some Unsolicited Advice to the FASB

And, so, FASB, I'm going to pretend that you have not switched off your brains on this, and provide you with some unsolicited advice.

First, your job is not to help financial statement users predict a "general price trend."  If future prices of oil could be predicted by past prices, then any person who can perform that trick is in the wrong business—unless they are already oil speculators. I have vivid memories of consulting for an oil and gas producer during a year in which they sold their entire production forward, because they speculated that prices would go down. Unfortunately for everyone involved in their ostensible "hedge," oil prices rose -- a lot. The operations managers I was working with, whose bonuses and shareholdings depended on oil revenues, were not pleased with the 'economists' at corporate headquarters who conjured that one up.  And, those guys were privy to the best public and non-public information money could buy.

Second, beware of the use of the term "meaningful."  To put it as gently as I can, the fundamental attributes of financial information are its relevance and reliability.  For example, subsitute either: (1) "relevant," or (2) "reliable," or (3) "relevant and reliable" in the above quotation for "meaningful" and see if it makes any sense.  It doesn't, of course.  More bluntly, you should treat "meaningful" as if it doesn't exist when discussing the properties of accounting information.  I suspect that "meaningful" owes its popularity to the fuzzy psycho-babble of the hippie generation (that would be me). SEC literature is already infested with "meaningful," and you need to put a stop to it before it infects accounting standards.

Finally, FASB, you should stiffen your backbone, clear your conscience and earn a gold star for bucking the single-minded, monied special interests.  You omitted any reason for concluding that an average price should be substituted for the period-end price, because there is none possible.  There is nothing you have ever done, and nothing that you could now say to rationalize the product of an SEC administration that would have babbled and blurted anything for the benefit of its political backers. 

If the new SEC honchos are still intent on mucking up oil and gas disclosures, they have the statutory authority to do it without any assistance from the FASB.  Gratuitous shilling shouldn't have to cost investors $500,000 per vote.

Announcing Our IFRS Survey!

This is a brief announcement of an online IFRS survey that I have prepared with Pat Walters of Fordham University. 

I invited Pat to collaborate with me because we have divergent views on the questions being asked.  Thus, I hope that together we have achieved a modicum of balance in the survey's design--particularly in the phrasing of the questions and response choices offered.  There are only 12 multiple-choice questions, and afterwards, I cordially invtie you to express your own opinions regarding its design by posting a comment to this blog post. 

We are also trying to reach many more stakeholders than any other survey has reached to-date on the IFRS adoption/convergence question.  To that end, we hope you will choose to email the link at the bottom of this post to anyone else whom you think might have an interest in taking it.

Pat and I thank you in advance for clicking here to take the survey, or by pasting this ugly link in your web browser:

http://www.surveymonkey.com/s.aspx?sm=pF0E3UgdSV_2bHMQvdAnXv8w_3d_3d

S-OX 404(b) for Non-Accelerated Filers: A Political Crime Waiting to Happen

Section 404(a) of the Sarbanes-Oxley Act, together with SEC rules implementing the provisions of the Act, require management to assess and report on the effectiveness of internal control over financial reporting (ICFR). It took a few years for the SEC to phase everybody in, but all public companies, large and small, are now subject to the requirement.

As pretty much everyone knows, however, S-0X 404 doesn't stop with a management report. Auditors get in on the action in Section 404(b). Therein is the lucrative requirement that an independent auditor attest to management's assessment regarding the effectiveness of their internal controls over financial reporting (ICFR). One person testifying before Congress has called the provisions of S-OX 404(b) the largest windfall to audit firm partners in history, and as I will soon describe, 6,000 more public companies await a new 'service' for which the benefits are, to be charitable, unclear.

Why S-OX 404(b) is Little More than Chicken Salad for Auditors

The corporate corruption scandals that got politicians moving on the Sarbanes-Oxley Act of 2002 were the result of fraud by CEOs and CFOs. ICFR can have little to no impact on the actions of the top executives, because they always possess the power to override internal controls, or sometimes to orchestrate collusive schemes that circumvent those controls. Thus, Section 404 cannot possibly do much to mitigate these particular sources of fraud risk; and there is no better example of that than Enron itself. I have been told (but have not verified) that Enron was the only public company to disclose with much pride and pomp that it paid its world-class, independent auditor to perform a separate evaluation of internal controls. Andersen's report was, of course, clean as a whistle.  

No one should doubt as well, that Enron's relationship with its auditors wasn't much cozier than the norm, either. No matter who the client is, and especially if it is a big one, material weakness are generally only reported after an error has occurred; i.e., after a control has obviously failed. Thus, all the machinations to test ICFR, and prevent a control from failing, don't add much beyond the testing of account balances that occurs as part of the regular financial statement audit.

So, it remains questionable at best, that S-OX 404(b) has created a safer environment for investors to trade their shares. Auditors, on the other hand have been champing at their bits, waiting for the SEC to throw them some fresh meat: the 6,000-odd smaller public firms (technically, "non-accelerated filers) who are not yet required to pay for an ICFR report.

Chicken Salad Days Appear on the Horizon

The auditors received some good news on that front a few days ago when the SEC announced that the stay of execution for non-accelerated filers would be extended only until their annual reports for fiscal years ending on or after June 15, 2010. Chair Schapiro and one other commissioner also issued statements to 'assure investors' that no further extensions would be granted.

Indeed, the SEC's Office of Economic Analysis has completed the last of the SEC's go-through-the-motions machinations to steer S-OX 404(b) through the gauntlet of thousands of irate registrants who resent the additional audit fees imposed upon them -- and the additional hoops they must jump through. And, what did OEA's report have to say? As it turns out, not much at all. Although changes to SEC and PCAOB guidance may have reduced the cost of S-OX 404(b) implementation for companies that currently must comply, OEA did not even address the key question: whether the costs of complying with S-0X 404(b) has been less than the benefits, or whether benefits can be expected to exceed the costs of compliance for the 6,000 companies in line to be plucked. It must surely be the case for non-accelerated filers that initial implementation costs are most onerous, especially in an economic down cycle. But nothing so obvious and significant was to be found in the OEA's report.

The Skinny on the Costs and Benefits of Section 404(b)

If I were writing OEA's report, I might have begun and ended with the following modest, albeit virtually dispositive, back-of-the envelope calculation: The total value of all public traded equities in the U.S. is very approximately $14 trillion, based on information available from indexes published by Wilshire Associates. Let's conservatively assume that each and every non-accelerated filer has a total market cap of $75 million, which is the maximum market cap for a non-accelerated filer. Even under that very conservative assumption, 6,000 non-accelerated filers comprise (at the very most) only 3.2% of aggregate equity values.

In the best of worlds (i.e., assuming that there is real information in an auditor's attestation report) can the new fees that auditors will charge these 6,000 smaller companies provide loss protection that will cover the billions of dollars in aggregate fees? Don't bet on it.

In fairness, the SEC would say that their hands are tied; S-OX directs the SEC to require ICFR attestation reports from all public companies. So, what should really happen is for Congress to wake up and amend S-OX to permanently exempt non-accelerated filers from the requirements of Section 404(b). Will it happen? Don't bet on that one, either.

What upsets me the most is that chair Schapiro is once again catering to the wishes of the Big Four instead of affecting much needed reform, as she has pledged to do. Schapiro should use her bully pulpit to inform Congress that they have created an obvious case of excess regulation. Notwithstanding the sorry fact that S-OX 404(b) has devolved into a waste of time for all issuers, to extend it to non-accelerated filers would be nothing less than criminal.

Instead, of rushing to require ICFR audits, why don't we just sit back and wait to see how many non-accelerated filers will voluntarily submit to an examination of their ICFR – just like Enron did. 

 

First Missive from the New Chief Accountant: Get Ready to Roll with IFRS

It came as no surprise that SEC Chief Accountant James Kroeker's first public foray, since Mary Schapiro deigned to remove "Acting" from his title, was to announce that the IFRS Roadmap has once again become a priority at the SEC. That should please his former employer, Deloitte, one of the Big Four IFRS Cheerleaders. To give you some indication of the goal-oriented culture from whence Kroeker came, here's a couple of examples from recent "surveys" Deloitte has been peddling.

In 2008, Deloitte asked financial professional what they thought were the benefits and costs of IFRS adoption. That sounds reasonable, but the next logical question appears to have been intentionally left off: which was whether respondents perceived that the benefits of IFRS adoption might not exceed the costs.

And, here's a sample question from a survey I received in my email this month:

In your view, what should the IASB's and FASB's approach be to convergence?

• Extend a comprehensive convergence plan over the next 5-10 years
• Achieve as much convergence as possible between now and 2011, and then focus on IFRS conversion at that point
• Wind down convergence efforts at this time, and support IFRS conversion
• Not sure

"Not sure"? What if you're "sure" or just pretty "sure"; but your answer is not one of the three that Deloitte is willing to tabulate? What if, heaven forefend, you are really "sure" that further convergence efforts would be a waste of time and money?

Answer to my questions: Should you dare opine that IFRS adoption is of no benefit, Deloitte doesn't want to have to acknowledge that gazillions of other like you perchance exist amongst the public, whose interests Deloitte has an ethical obligation to serve. These were not surveys; they were charades. They were put together to serve special interests – at the expense of the investors that Mr. Kroeker now is supposed to be working to protect.

Thus far, the text of Kroeker's remarks have yet to appear, as is customarily the case, on the SEC's website. Consequently, my comments will be based on press coverage from the following sources: CFO.com, Reuters and WebCPA.

Be Very Afraid … of a "Race to the Bottom"

Some people took IFRS adoption for dead, but Kroeker came to say that it has returned to becoming a priority at the SEC, in part because the financial crisis may have underscored its importance. It appears, for example, that without a single authority over standards, the U.S. and Europe may get caught up in a "race to the bottom" to set accounting standards most favorable to banks and to the detriment of investors.

While it is true that the EU has made its fears that lower-quality accounting standards in the U.S. will cause its banks competitive harm, more recent events don't comport with a race-to-the-bottom scenario. The FASB (as I have written here) is proposing that all loans should be fair valued. The FASB is clearing saying to the IASB, 'You can take the low road if you want, but we'll take the high road.' (By the way, there's no way that the IASB will follow the FASB's lead on this. If Sir David Tweedy so much as dreamed of requiring fair value for loans, he'd call up Charlie McCreevy the very next morning to apologize.)

Nonetheless, I do concede that, in the absence of SEC intervention, a race to the bottom is at least theoretically possible. But, for at least two pretty obvious reasons, that possibility is remote, if not downright silly to contemplate.

First, as a general matter, it is not clear that competition among jurisdictions inevitably results in a race to the bottom. As one of many possible counterexamples, consider the development of the state laws governing corporations. The Delaware laws are regarded by many to be least restrictive; however, many corporations choose to register elsewhere. There are two lessons from this that I can think of: (1) there is not necessarily one set of rules to suit all tastes; and (2) the stability and longevity of our system of corporate laws indicates that multiple law givers are preferable to giving the federal government a monopoly on that role. Thus, notwithstanding the 99 other reasons (okay, 10) I can think of, it is far from clear that granting a worldwide monopoly to the IASB is the most efficient thing to do.

Second, and this is the biggie, whatever Kroeker might fear about incentives of standard setters to debase their own coinage, his job, whether he likes it or not, is fundamentally to prevent a race to the bottom from even getting past the starting line. Various securities laws clearly state the authority of the SEC to set accounting standards for public companies. It must be said, however, that the SEC has published its policy that, for the most part, has left standard setting to the FASB. (For the rule wonks amongst you, that would be Section 101 of the codified Financial Reporting Releases.) Kroeker weakly assures us that the SEC will always be active in interpreting accounting standards adopted by SEC registrants, but the SEC historically has done much more than that – by judiciously picking its moments to pre-empt or outright reject FASB pronouncements.

Given Kroeker's own stated preference for uniformity in bank accounting and his own view of its significance in the global financial order, no opportunity could be more ripe than for the SEC to take the initiative on loan accounting. All Kroeker need simply do is to endorse the FASB's proposal to measure all loans at fair value, and counsel the IASB that they should get with the program. That oughta eliminate any fears of an accounting standards race-to-the-bottom.

But, alas, world peace is a more likely scenario; fair value for loans doesn't fly in the EU, so it surely cannot fly with Kroeker's former colleagues at Deloitte. Who wouldn't prefer to know what Kroeker's thinks about loan accounting than the Roadmap? But it's a steady diet of Roadmap that we will surely be force fed in the months to come.

Saying So Doesn't Make it So

As was sadly the case when Christopher Cox was SEC chair, I found nothing in Kroeker's remarks to indicate that he cares much about citing evidence in support of his ideology. Take these accounts:

• Reuters – "Kroeker … said … that in the more than 200 comment letters the SEC has received on the proposal, it was 'resoundingly clear' that people agree there should be a single set of global high-quality accounting standards…"
  
• WebCPA – A single set of global accounting standards is "…like motherhood and apple pie."

Given, as I reported here, that the overwhelming majority of investor responses to the Roadmap proposal want to tear it up, I don't know where he comes up with this stuff. And, don't forget about Deloitte's paranoia about even broaching the question in its "surveys." (By the way, Wayne Carnall, former PwC partner, and chief accountant of the Division of Corporation Finance had characterized the response rate as a pittance, and now Kroeker is spinning 180 degrees away from that.)

Ironically, Kroeker delivered his remarks before a meeting convened by the New York State Society of CPAs. It was there that another candidate for chief accountant, Charles Niemeier, trashed the whole notion of IFRS adoption for what it was: a full-employment act for the current chief accountants' former colleagues.

Not only were Kroeker's and Niemeier's positions as different as black and white, but the quality of their inputs and reasoning couldn't be more starkly contrasted. Niemeier's inspiration clearly sprang from a foundation of cited broad-based analyses produced by published rigorous, peer-reviewed, independent research. The source of Kroeker's remarks apparently came from nothing more than his own wishful thinking.

Emergency Post: Chief Accountant Candidates Could be Down to Just Two

My practice has been to post about once per week, and I had completed my latest less than a day ago. I'm coming back at you so quickly, because Bloomberg News has just come out with this:

"Securities and Exchange Commission Chairman Mary Schapiro settled on two finalists to be chief accountant, acting director James Kroeker and Baltimore money manager Jack Ciesielski, people familiar with the matter said.

Kroeker, a former Deloitte & Touche LLP partner and acting chief since January, and Ciesielski, who has defended mark-to- market accounting, met with commissioners this month to discuss their interest in the job, said the people who declined to be identified before an announcement …" Continued in article.

With the passage of time, it seems increasingly less likely that the next Chief Accountant will come from the Big Four; it would break a string of the last six in a row (more or less, I think). Especially given the records of the most recent guys in charge, I think that most would agree that it's time for a change in emphasis.   

Appointing Jack Ciesielski, a wise and straight-shooting investor advocate, would send a strong signal from the SEC that the voices of special interests would be muted henceforth. But, if Kroeker is promoted to be the permanent big cheese as an appeasement to the Big Four, it will look to much like Chair Schapiro lacked the gumption to face down a special-interest juggernaut. After all, Kroeker's only bona fides as an investor advocate are his leadership of a recent fair value study that chafed the chops of the banking industry big time. Other than that, the public pretty much knows only of his Big Four acculturation (and the inevitable accompanying baggage), and that he was appointed to deputy chief by the best imitation of a paperweight ever to hold the title of chief accountant.

Bonus Coverage

This morning, I merely smiled to myself at the audacity of two missives (missiles?) from PwC that came across from two very different sources. Now, after the sobering news from Bloomberg, not so much. These guys are nothing, if not tenacious.

First, there was a letter to academics directing them in no uncertain terms to include appropriate IFRS-related materials in the courses—else, their students would be deemed insufficiently programmed to serve as audit highly paid drones according to PwC's new hiring hiring criteria:

"PwC believes it is important for our new hires to have sufficient knowledge and skills about IFRS to transition easily into our practice. Therefore, we will include IFRS in the basis for making decisions about an applicant's level of technical and professional skills and knowledge. Starting in Fall 2009, we will expect that applicants will have used our learning opportunities or other means…"  [italics supplied]

Bob Jensen, a retired academic and former American Accounting Association Educator of the Year called the letter in remarks on the AECM listserv an "insult to the academy of accounting educators." ... " and "I've always admired PwC.  But I can only hope that they lose some terrific accounting graduates because of this Orwellian Big Bully strategy." 

Ditto from me, and sad to say some faculty seem all too willingly to line up and salute the flag.  About a year ago, I asked a first-year assistant professor at a smaller university, that was extremely proud of its record of placing students with the Big Four, why they were looking to add an entire course on IFRS to their curriculum.  Her answer was simple, yet devoid of any trace of irony or regret: "It's our job to give the Big Four what it wants."

Second, revisionist history continues in PwC's latest IFRS First newsletter: 

"Due to a new administration, ongoing economic issues, and responses to the proposed roadmap, there is some uncertainty around the final timetable for adoption of IFRS in the US. However, the responses to the Proposed Roadmap indicate that there still is strong support for a single set of global accounting standards. [LOL] We remain confident that:

The SEC is interested in moving forward with IFRS
The SEC will continue to approach the change with a thoughtful, measured process
The SEC will ultimately propose a revised roadmap
Adoption of IFRS in the US is inevitable " [italics supplied]

Has anybody else noticed that the mantra of "single set of high-quality global accounting standards" has been truncated to exclude that pesky 'high-quality' part?  The marching orders to all who have been captured by the Big Four's largesse is becoming more and more pointed:  'Forget quality. Forget convergence. Get with the IFRS program … or no more soup for you!'

If Mary Schapiro doesn't take a strong stand for investors on the chief accountant appointment, then  "inevitable" will become sooner than you can say PricewaterhouseCoopers.'

Which SEC Roadmap Comments Matter, and What They are Saying

A couple of commenters on the last post found fault with my assertion that the "low" response from issuers on the SEC's IFRS Roadmap proposal is pretty much a non-issue. For example, commenter Andy argues that self-selection bias may well exist because only "... those who feel strongly against or for, will make their views known."

I do agree with Andy in general, and there is strong empirical evidence to support that sort of tendency in some circumstances.* But, I don't agree that it is the phenomena that operates on issuer response rates to an SEC proposal such as the Roadmap.  I consider only the following four factors to affect the decision of an issuer's CEO to submit a comment letter: (1) one's stake in each potential outcome; (2) the subjective probabilities of each potential outcome; (3) the costs of commenting; and (4) the subjective probability that a comment letter can favorably influence the SEC's decision.

Thus, strong opinions are not enough – and perhaps irrelevant – to move a CEO to speak out on the Roadmap. The issuers who determined that investing in a comment letter was worthwhile did so.  For whatever reasons a lot didn't, but it is unlikely that it was systematically related to the 'strength' or substance of their opinion.

Moreover, the third and fourth factors, above, indicate that if the comment submission rate is judged insufficient, the Cox-lead SEC should bear some of the responsibility for that. For example, the cost of commenting is influenced by the ease of doing so. I, for one, wasted a full day out of my life to draft one, and then abandoned the project out of frustration. It took just too much effort to respond to all of the niggling questions, and I felt that anything that didn't fit the particular and numerous questions the SEC was asking would not even be classified, much less read.

With regard to the fourth factor, above, it certainly didn't help that the Cox SEC all but threw in the dust bin the strident and numerous criticisms of their proposal to eliminate the IFRS-to-GAAP reconciliation requirement. The saber rattling by the EU, and the relentless lobbying and PR by the Big Four doesn't help either, as they only lend credence to the proposition that bigger fish will have the ultimate say.

Moreover, issuer comments are in my view, a sideshow compared to investors.  If the SEC largely ignores them, that's how it should be. For example, let's take a look at an excerpt from Wal-Mart's response:

"For a global company like ours, [the benefits of IFRS adoption] include standardized reporting systems, efficiency in accounting training, and efficiency of financial statement review. However, these benefits are limited to the extent that various government and regulatory bodies in countries we operate in adopt IFRS as issued by the IASB for all oftheir reporting requirements. Failure to achieve this consistency in reporting standards minimizes or eliminatesany benefits. At the present time, we do not see any other significant benefits to offset the expected costs in adopting IFRS." [italics supplied]

Is Wal-Mart providing an honest assessment of the costs and benefits of IFRS, or do they have a hidden agenda? I haven't looked at Wal-Mart's financials in a few years, but in the years I did, I was amazed at how steady was their growth rate, and their profit margins were like a steady drum beat year after year. Wal-Mart, being in a very straightforward business with short cash cycles and tending to grow without a lot of M&A activity, probably doesn't face a lot of thorny accounting issues where GAAP and IFRS are significantly different. Except for one: asset impairment, where (as I have written here) IFRS can create more earnings volatility than GAAP. I suspect that avoiding the IFRS long-lived asset impairment standard could be their real agenda.

So, the long and short of it is that we can argue about whether the issuer response rate is low, but the SEC shouldn't be paying much attention to issuer comments anyway – except, perhaps, to help them divine what the costs of IFRS conversion to issuers might be. Evaluating the potential for IFRS to improve the quality of information provided to investors should be the purview of investors and others with financial reporting expertise, and who have no obvious axe to grind (academics, for instance).

And what of the auditors' strongly pro-IFRS comments?  I believe they actually have a role in the process, but not the one they have chosen.  I am reminded of a comment made by the irascible college basketball coach, Bob Knight. When asked about his position on a proposal to reduce the time on the 'shot clock' from 45 to 35 seconds, he said something like, "I don't care if you make it 5 seconds! We're good enough to play that game, too; and if somebody is dumb enough to thnk that the best basketball team will win that way, that's their problem."

What I mean to say is that the only thing I want to know from the auditors is akin to Bob Knight's shot clock response.  In switching from IFRS to GAAP will auditing practices and the reliability of an auditor's report be affected?   The Big Four never features (or perhaps even deigns to answer) those kinds of questions, because they are self-evident and non-self-serving: auditing procedures should not change very much, but the reliability of the auditor's report will decline due to greater reliance on management's judgment.

I'll readily admit that everyone is supposed to have a hidden agenda (except me), but with that caveat, I'll close with a selection of what I believe are some of the more revealing comments on the Roadmap proposal by a few of the organizations which, one might say, should hold 'super votes.'**

In summary, while the FAF and the FASB continue to support strongly the ultimate goal of a single set of high‐quality global accounting standards as part of a global financial reporting system, in our view, additional study is needed to better identify, understand, and evaluate the strengths, weaknesses, costs, and benefits of possible approaches the U.S. should take in moving toward that goal. – FASB

Until a single set of standards that produce such a result [high quality standards] exists, with a demonstrated record of compliance andenforcement, we believe it is premature and unwise to move away from U.S. GAAP… [W]e have seriousdoubts as to whether the proposed roadmap, as currently envisioned, will tangibly benefit investors' interests…In our view, the proposal fails to provide sufficient support as to why it presents a better course of action than the current on‐going convergence efforts… – Investors Technical Advisory Committee, FASB

[L]ittle existing research directly addresses whether U.S. investors, issuers, and markets would benefit fromimplementation of IFRS in the U.S. … We recommend further analysis of the costs and benefits of a mandated transition to IFRS for U.S.issuers, investors, and markets. – American Accounting Association, International Accounting Section

In our opinion, converting to IFRS is a solution without an underlying problem. In fact, we have never heard aninvestor in our company, any stock analyst covering Marriott, or any lender with which we do business in theUnited States or abroad suggest to us that they would prefer we report our results in IFRS. – Marriott

We believe that the costs to convert to IFRS will be extraordinary. The total cost to convert to IFRS is extremelychallenging to capture since it involves both quantifiable cash costs, as well as the cost that the distraction andreallocation of resources will cause to businesses. – McDonald's

Amen.

_________________________________

*See, for example, Richard J. Cebula, "Strong Presidential Approval or Disapproval Influencing the Expected Benefits of Voting and the Voter Participation Rate," Atlantic Economic Journal, (2005)33:159-167.

**Extracted from a document of excerpts presented to members of NASBA

The Comments on the SEC Roadmap are Clear: Make a U-Turn

There are some definite signs that Mary Schapiro is getting closer to naming her Chief Accountant. For example, I received an email from Denny Beresford, former FASB chair, who was left with the impression from a reporter that an announcement would be coming this week. Indeed, because of recent events I'll be discussing in this post, I'm inclined to believe that it will indeed come to pass.

The Chief Accountant appointment will clearly be setting the tone for the debate on the IFRS Roadmap proposal. But I am also getting strong vibes that, this time around, the many negative comment letters in response to the proposal will be a significant factor in the SEC's deliberations —as opposed to Christopher Cox's tone deaf handling of the elimination of the IFRS-to-GAAP reconciliation requirement. Because of that, the IFRS supporters are spinning the comment letters like crazy.

Most recently, CFO.com reported on remarks emanating from Wayne Carnall, Chief Accountant of the SEC's Division of Corporation Finance. He is generally seen to be an IFRS adoption proponent, and rumored to be a candidate for the Chief Accountant in the Office of the Chief Accountant -- yes, I know it's confusing, because he is already a 'chief accountant.' There are, to the best of my knowledge at least four positions at the SEC bearing the title of Chief Accountant. There's one each in the functional divisions of enforcement, corporation finance, investment management; plus the"Chief Accountant to the Commission" with one's own staff to serve the Commission as its principal advisor on accounting and auditing matters. That's the seat of power that everyone covets, and it's the one that has lacked a permanent possessor since Mary Schapiro took over from Cox's gang.

Anyways, Wayne is reported to have expressed his disappointment that so few public companies have even bothered to express their views on the Roadmap proposal:

"A total of 240 letters were received, about half of them from registrants. Cornall [sic] called that level of response 'disappointing.'

'Only about 1% of the companies in the United States that would be impacted by this change, if we were to adopt it, decided to comment. I thought that was a surprisingly low number,' he said.

He noted that a pair of FASB staff positions issued in March on what he called a 'relatively small, narrow item' — valuing assets in illiquid markets — got 700 comments in a 15-day comment period. 'Yet on a proposal to change the reporting framework in the United States we got 120 comments" from public companies during a 120-day comment period."

Wayne seems to be implying that nothing of significance can be inferred from such a low (in his judgment) response rate. He might have a point if the responses were equivocal, but that's simply not the case.

I read only a few of the comment letters, but I know of at least one person who read them all. That would be Gaylen Hansen, a partner in a Colorado CPA firm, and self-described detractor of IFRS adoption in the U.S. Among other high profile national service positions that Gaylen holds, he is chair of the Strategic Initiatives Committee of the National Association of State Boards of Accountancy (NASBA). The data on roadmap proposal comments displayed here is straight from his presentation at recent NASBA regional meetings (video, here):*

The problem for Wayne and other IFRS supporters is that the data is so darn unequivocal against the IFRS Roadmap proposal that any errors due to small sample size would have to be tsunami-sized in order to reverse the results. Public companies disfavor the Roadmap by a margin of exactly 2:1; and the public companies that express "strong" opposition to the Roadmap proposal outnumber all supporters, however strong, by exactly 1.5:1. Perhaps even more damning to the Roadmap proposal is that not a single investor group expresses "strong" support, and the overwhelming majority want to tear it up.

Not even the AICPA, an IFRS adoption cheerleader for years, can spin a very positive message out of the comment letters, but eschewing all references to actual data, spin fast and furiously they did with something they call an "analysis":

"While many expressed support for the goal of high-quality globally accepted accounting standards, the request for comments produced numerous critics of the SEC's proposed roadmap.  Commentators had serious concerns about the cost of adoption, the benefits of adoption compared to convergence, and whether IFRS were in fact as good as or better than U.S. GAAP. ….

While in the minority, some U.S. registrants generally supported the roadmap and mandatory adoption in the near term. [i.e., the majority voted "nay"] These organizations noted the benefits of global comparability, increased transparency, decreased cost of global financial reporting and the belief that converged standards would fall short of the benefits accruing from use of one global set of accounting standards. …

Responses from investor groups were mixed." [emphasis supplied]---

"Mixed"? While they were relatively few in number, it's safe to say that the major U.S. investor groups one normally expects to weigh in on accounting standards did so here. I suppose one would be technically accurate to state that investors were not unanimous in their strong opposition to the Roadmap proposal, but saying that 'most were strongly opposed' could only be an understatement. (Sometimes, I wonder if the AICPA outsources its communications department to the National Rifle Association.)

Even so, the AICPA's spin is not nearly as blatantly disingenuous as PwC's recent press release:

"Despite uncertainty about timing of the move to International Financial Reporting Standards (IFRS) in the United States, PricewaterhouseCoopers (PwC) maintains that the adoption of IFRS in the U.S. is inevitable [emphasis supplied], and that there is still overwhelming support for a single set of global accounting standards.

We expect steadily increasing convergence activity followed by eventual conversion to IFRS. …

Additionally, all U.S. businesses will face an unprecedented wave of U.S. GAAP changes, influenced by - and, in many instances, conforming to IFRS - over the next several years."

Having to make an explicit choice between the Big Four, and now, practically everyone else, is a scenario that a new SEC chair would certainly like to avoid so fresh out of the box. But, so far, Mary Schapiro appears to be handling it brilliantly: by waiting for IFRS to self-destruct.

"Inevitable"?  Not even close to that anymore.  'Implosion' more aptly describes what is now occuring, with almost shocking rapidity. On the overseas front, Charlie McGreevy of the EU and the European Federation of Accountants (FEE) have been applying countervailing pressure on the IASB to de-link itself from U.S. GAAP -- else the EU is threatening to part company with the IASB. It's a highly credible threat, and it would leave the IASB with little more than the Asian powers, Australia and a gaggle of third worlders no capital markets of their own to speak of.

On the embattled U.S. front, the FASB, without a breath of mention of convergence, has announced its intention to require that all financial assets, including loans, would have to be presented at fair value on the balance sheet. To abandon McCreevy's beloved 'amortized cost' accounting for loans investments in debt instruments would certainly be a bridge too far for EU regulators; and most encouraging to moí, the FASB by this action may finally be tacitly admitting that convergence is holding them back from making urgently needed changes to accounting standards that have contributed to the recent bout of financial havoc.

So, at this rate, the long-awaited appointment of a Chief Accountant may turn out to be an anti-climax -- which is just the way Mary Schapiro would like it.

--------------------------------------------

* Gaylen's tabulation of the Roadmap comment letters excludes the Big Four, AICPA and others with an obvious pecuniary interest, foreign companies, foreign accountancy groups, foreign companies currently using IFRS, students and responses that defied classification.