The Accounting Onion

Autonomy: Investors are Entitled to Know what HP's Management Knows -- by New Year's Eve

Hewlett Packard Co. claims they were 'misled' (to put it mildly) by accounting 'misstatements' (to put it mildly) into overpaying, on the order of $8 billion, to acquire Autonomy. But, if anybody outside of HP has precise knowledge of those questionable accounting practices, they're not letting on in their public disclosures (e.g. Form 8-K):

"Following the completion of its annual review of its goodwill and purchased intangible assets for impairment, on November 20, 2012, HP announced that it recorded a non-cash charge for the impairment of goodwill and intangible assets within its Software segment of approximately $8.8 billion in the fourth quarter of its 2012 fiscal year. The majority of this impairment charge relates to accounting improprieties and disclosure failures at Autonomy Corporation plc ("Autonomy") that occurred prior to HP's acquisition of Autonomy, misrepresentations made to HP in connection with its acquisition of Autonomy, and the impact of those improprieties, failures and misrepresentations on the expected future financial performance [emphasis supplied] of the Autonomy business over the long-term…. HP does not expect the impairment charge to result in any future cash expenditures."

Which may explain why the reports in the press are all over the place. Roughly ordered from least to most egregious, here are some possibilities gleaned from what I have read thus far:

• Autonomy, as a UK company, allegedly exploited the mutability of International Financial Reporting Standards (earnestly referred to by its promoters as "principles") to recognize revenues earlier than would have been permitted by U.S. GAAP. This allegation is founded on the belief that Autonomy often bundled two products in its contracts with customers: software and data storage services. If Autonomy wanted to be as aggressive as possible in its revenue recognition, it would maximize the allocation of the total consideration to be received under the arrangement to the software element under a contract (which might have been recognized upon delivery) and too little to the storage services (which is recognized over time).
• To add insult to injury, the revenue from the software sales in the forgoing scenario could have been recognized prematurely if they were in the form of licenses, which perhaps should have been accrued over time. Again, I'm not sure that IFRS provides much in the way of practical constraints. The applicable standard (IAS 18, para. 20), provides that licensing revenue would be recognized up-front when the agreement is for a fixed fee and the licensor has no further obligations. But, whether that fits the facts and circumstances of Autonomy's business is not known. Moreover, IFRS does not explicitly state that these are the only fact patterns that would support up-front recognition of license fees.
• Expenses were allegedly shifted out of 'cost of sales' and into marketing to give the impression of investments in the brand, and to inflate current gross margins.
• Software was sold or licensed (I don't know which) through third-party resellers. The most serious allegations could be that either the resellers or Autonomy itself fabricated these transactions.

As an aside, it's also very curious that none of the information HP has put out squares with the views of Autonomy's auditor before the acquisition, Deloitte. They firmly stand by their audit – if you want to call it that, for if judged by U.S. rules (SEC, S-OX, PCAOB) Deloitte was not in a position to be considered independent. The very nature of the non-audit services provided – for example, providing advice on executive compensation schemes – makes it so. Moreover, Deloitte's revenues from those non-audit services were pretty lucrative: it has been reported that for every dollar collected from audit services, Deloitte collected approximately $1.10 from providing non-audit services. If Autonomy's accounting practices were too aggressive, would Deloitte's staff have had the gumption to push back given the stakes?  I'm just asking.

As another aside, I wonder about the accuracy of the last sentence in the disclosure tidbit I provided above:  "HP does not expect the impairment charge to result in any future cash expenditures."  In a narrow sense, this is too obvious to have to mention:  that recording an impairment charge does not affect cash flows in and of itself.  But if HP is actually stating that there will be no future cash outflow effects resulting from the Autonomy affair, then that should raise a big red flag.  What about future legal costs in an attempt to recover damages from Autonomy's former managers and shareholders?  Or, if business is a lot worse than they thought, are restructuring costs imminent?

Getting back to HP's disclosures about the facts and circumstances surrounding the goodwill impairment charge, it may have complied thus far with the letter of the SEC's rules, but there are still far too many unknowns to conclude that HP has been adequately forthcoming. What I do know, however, is that SEC rules will eventually compel HP to tell the public in clear language what all the fuss has been about.

The rules I am referring to are set forth in Item 303 of Regulation S-K, Management's Discussion and Analysis of financial Condition and Results of Operations (MD&A). According to my calculations, HP's next MD&A should be filed no later than the last day of 2012 in its annual report on Form 10-K.

The clearest indication of what that MD&A is supposed to contain with regard to the Autonomy affair is from well-known and oft-repeated SEC's interpretive guidance from 1989. It reminds filers that the purpose of MD&A has always been, from the time it was first proposed, to give investors the opportunity to see the company "through the eyes of management." In this instance, such a statement can only mean that investors are entitled to the following specifics: what management knows as of the date of the filing; how they know it and when they came to know it; how it changes expectations of future profitability and liquidity (quantified to the extent possible), and most important, the actions that management is currently taking, and may likely take, to mitigate the negative developments.

Sarbanes-Oxley only requires that the SEC review (in unspecified detail) HP's disclosures every once in three years. But, following on the heels of an announcement of an $8 billion impairment charge to goodwill and a 12% shock to the share price of such a high profile company, the only accetable staff response to the events at HP would be to review HP's MD&A and related disclosures with a fine-toothed comb as soon as its collective New Year's Eve buzz wears off.

One could reasonably argue that the SEC's interpretive guidance on MD&A is too general to be enforceable; and even if it were, that it takes disclosure regulation a bit too far. But, it seems to me that this is the kind of situation that belies such propositions.  We, the public, are counting on the SEC staff -- under its new chair Elisse Walter -- to hold HP's feet to the fire.

I hope that Ms. Walter's is thinking that this could be her first big test -- and is eager to face the challenge.

Securitization Accounting and Grand Theft Auto

Many books and articles have been written to describe the mishaps that led to the Great Recession of 2008, but few have done so while putting the role of accounting standards and auditing in context. I reported back in January 2010 that Paul Krugman at least was cognizant enough of accounting to acknowledge that we do not presently have honest financial reporting standards that let investors make good decisions and that "… forces management to behave responsibly." But, other than changing the name on the sausage packaging from GAAP to IFRS, detailed suggestions for achieving fundamental change have been exceeding rare.

NC State accounting professor Paul Williams also drew inspiration from Krugman's column and the financial crisis for a brief paper entitled The Wrong Metaphor, which I recently heard him present to the Public Interest Section of the American Accounting Association. Much as I have (but certainly with some important differences that you should read for yourself), Williams has come to the conclusion that a paradigm shift is needed for accounting to re-assume its proper role in society. I wish we could have much more from Williams reagrding what he thinks should be changed and how to make change happen.

A recent paper by S.P. Kothari and Rebecca Lester of MIT, The Role of Accounting in the Financial Crisis: Lessons for the Future, is very strong in its description of flawed accounting and its potential role in the past crisis. These are some of the basic messages:

• The accounting rules provided originators of subprime mortgages (SFAS 140) the opportunity to record economically specious gains on securitization transactions.
• The accounting rules also permitted regulated financial institutions that invested in financial instruments created out of subprime mortgages (MBOs and CDOs) to delay recognition of likely losses; which, in turn, distorted measures of capital adequacy.
• Estimation errors, most significantly estimates of fair value, committed by issuers of financial statements and their auditors exacerbated the accounting misstatements inherent in the accounting rules.

Although, like Williams, the Kothari/Lester did not provide much in the way of "lessons for the future," I would still highly recommend it. Accounting students could, and should, read it if only for its lucid examples and explanations of the arcane and flawed accounting rules that are applicable to securitizations.

The purpose of this post is to distill the analysis of Kothari/Lester so as to further discuss "lessons for the future." Before I do that, however, I want to tell you about an email correspondence I had with S.P. Kothari after I read their paper. Since I was preparing my own remarks for academics on the topic of IFRS adoption and the future of U.S. accounting, I asked him whether he thought it more or less likely that promulgation of more appropriate fair value or securitization standards would occur if the SEC continues to pursue convergence with IFRS. This was the response:

"…I think convergence will harm promulgation of more appropriate standards because a converged standard setting body would become a monopoly that would be pulled in all different directions by its constituencies."

Clearly, whatever the "lessons for the future" may be, adoption of IFRS is not one that he had in mind.

 

Securitization Accounting as Grand Theft Auto (not the video game)?

The process of securitization reminds me of large-scale car theft ring.* To obscure the link to the illegal 'acquisition' of cars, much like subprime mortgage loans, the cars are almost immediately chopped up into parts and re-sold. As a business model, stealing cars works only because the cost of obtaining a car is low; but let's ignore that for the moment and assume that someone actually establishes a legit buy/chop auto parts business – in other words, cars are bought for full price and chopped up for the sale of parts. Here is a representative sent of journal entries:

Day One – buy a car:

Dr. Car (at cost)                               30,000
      Cr. Cash                                                   30,000

Days Subsequent – chop up the car and sell its parts:

Dr. Cash (from sale of parts)            25,000
Dr. Engine (at estimated fair value)   7,000
     Cr. Gain on sale of parts                            2,000
     Cr. Car**                                                    30,000

I readily acknowledge that second entry does not comport with current GAAP.  I am using to illustrate securitization accounting in the context of a highly simplified example.  Having stated that, however, I don't see any reason (although others might) that the accounting for a chopped car should be different than the accounting for a chopped subprime mortgage.  I can't abide mixed-attribute accounting systems, and believe that college-educated professionals should not be adding apples and oranges, much less elevating the error with misleading names like "statement of financial position."

If you can set aside any cavils you might have with respect to my violation of current GAAP, please answer this question for me:  Would you invest in a business whose financial statements were based on journal entries like these? They sure do look legitimate, but common economic sense would dictate that the second journal entry must overstate the real profit on the resale transactions. First, as Kothari and Lester observe in the securitization context, "how is it possible that the sale of an asset originally recorded at one value could generate income and higher asset balances upon merely transferring this asset to another entity?" I suppose one could say that butchering a chicken should add value such that the sum of the parts is greater than the whole chicken. But that's because there's only one way to one way to obtain chicken parts – first, you gotta grow a chicken. However, one doesn't have to manufacture a car just to obtain a spark plug; or to originate a subprime mortgage loan just to create contracts containing a particular pattern of future cash flows.

The second reason indicating that the second journal entry is misleading is that the flawed business model would not be able to earn an economic profit over a full cash-out-cash-in cycle (i.e., buy car Þ chop Þ sell Þ reimburse for defects under warranty). If the engine could actually be sold for $7,000 (and generating an overall profit of at least $2,000), then I'll be a monkey's uncle!

The Lessons for the Future

In order to determine whether a better accounting is feasible, we need to be able to identify the sources of overstated income. With respect to both the car parts example and securitizations, overstated income could be the result of any of the following:

1. Kothari/Lester do not refer to this explicitly, but the most subtle and important aspect of the problem, in my view, is the unavoidable change in the 'unit of account' from the original asset (e.g., car, subprime loan) to the retained portions (e.g., engine; or in the case of securitizations, a servicing asset, and the right to residual cash flows). For example, erroneous accounting will occur because the values of the components of the car will not exactly sum to the pre-chopped value of the car itself; it doesn't matter how one chooses to measure value.
2. The appropriateness of the basis of measurement for the retained assets: such as historic cost, fair value or replacement cost.
3. Given a basis of measurement, biased measurement of the assets retained (which auditors fail to correct). Kothari/Lester surmise that this is the most significant source of overstated income.
4. Unrecognized or understated liabilities (e.g., a warranty obligation on the car parts, or a written put option for underperforming loans).

As to mitigating these sources, I have provided my two cents on #3, the biased estimate problem in a number of posts, the latest of which is here. Regulators have tried over and over again to make incremental improvements to auditing standards, with no perceived help in increasing the public's confidence that auditors can play a significant role in averting a large-scale financial crisis. It is time to abandon any notion that: management can provide unbiased estimates of value; and/or that auditors are intellectually capable or even inclined to provide a independent and knowledgeable assessments of management's estimates.

Therefore, when financial statements require estimates of current values and uncertain future events, these estimates should be produced by third parties – i.e., neither management, nor the auditor. The auditor's role should be limited to:

• Verification of the components of financial statements that can be verified.
• Verification of the inputs to current valuations that can be objectively measured, and hence, verified.
• Verifying that third party experts charged with measuring current values and expectations of future events have performed the procedures they said they would perform.

As to #2, above, the conventional wisdom is that historic cost accounting is fact-based, objective, understandable, and even verifiable. We have learned the hard way that this is a fiction; however historic cost accounting has been practiced. To get to a point where financial reporting can be freed from perverse incentives for management to produce biased estimates, standard setters must dedicate themselves to the establishment of accounting standards that yield financial statements capable of being audited and understood by auditors, investors, credit rating agencies and the like. Securitization/loan accounting standards clearly indicate that historic cost "principles" when applied to financial instruments create nothing but a big mess.

Saving the worst for last, the unit of account issue (#1, above) may defy a principles-based solution, but I still want to take a stab at it. Referring to the sample journal entries, the higher the values assigned to the assets retained, the higher will be the reported gain. This suggests, once again, replacement cost is the most appropriate basis of accounting, for it would require measurement based on the least costly way to replace the asset subject to being measured. For the car example, the business model indicates that the most economical way for the entity to acquire an engine would be to buy a car, chop it up, and sell all of its parts except for the engine. Thus, the marginal cost of an engine might be essentially zero – and the result would essentially eliminate the gain recognized in the second journal entry. Indeed, the loss recognized in the second journal entry by this logic would be the telltale sign of a flawed business model.

The same logic used to measure the replacement cost of the engine could easily apply to securitization assets such as servicing rights and residual interests, and leads to an analogous question: Did the subprime loan origination/securitization business model only work, or appear to work, because of favorable accounting treatment? These are questions worthy of further research, but if the accounting for securitizations had been more reasonable, we would already have reasonable answers.

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*Kothar/Lester address both the accounting for securitizations by the originators of subprime loans and the subsequent accounting by investors in the financial instruments created by securitization. I am only looking at the former in this post.

**I am assuming that costs of chopping the car are negligible or are expensed in a journal entry not displayed. Capitalization of these destruction costs would affect the form of the journal entries, but it would not affect my conclusions.

Stock Compensation, Tax Law, Financial Reporting and Facebook's IPO

Last August, I wrote a post in which I expressed my dismay that Carl Levin (D-Michigan) and Sherrod Brown (D-Ohio) are trying to make tax law based on the premise that FASB rules for stock options are caviar -- when the stark reality is that they are chopped liver (or worse). The senators are oblivious to the fact that the evils they decry lie in the financial reporting rules (hewn from decades of political wrangling, grandstanding and backroom dealing), and not the income tax rules; and worse, their proposal to reduce the deductions available to corporations while keeping the same taxable income for the individual who would exercise options has no precedent in tax policy, logic or fairness.

This current post is in response to Senator Levin's recent speech on the Senate floor in which he pressed the same dubious points. But, the really interesting part are the circumstances he relates regarding Facebook's upcoming initial public offering of its shares:

"According to its filings, when Facebook goes public, Mr. [Mark] Zuckerberg plans to exercise options to purchase 120 million shares of stock for 6 cents a share. Mr. Zuckerberg's shares, obviously, are going to be worth a great deal more than 6 cents, a total of about $7 million; they will apparently be worth more than 600 times as much, something in the neighborhood of $5 billion.

Here's where the tax loophole comes in. Under current law, Facebook can – perfectly legally – tell investors, the public, and regulators that the stock options he received cost the company a mere 6 cents a share – that's the expense shown on the company's books. [This is wrong – see Footnote.] But the company can also – perfectly legally – later file a tax return claiming that those same options cost the company something close to what the shares actually sell for later on – perhaps $40 a share. And the company can take a tax deduction for that far large [sic] amount. So the books show a highly profitable company – profitable, in part, because of the relatively small expense the company shows on its books for the stock options it grants to its employees. But when it comes time to pay taxes, to pay Uncle Sam, the loophole in the tax code allows the company to take a tax deduction for a far larger expense than they show on their books. …

Now, the end result is that a profitable U.S. corporation – a success story – could end up paying no taxes at all for years, even decades." [italics supplied]

To Levin, the Facebook IPO is a dramatic illustration of an inequitable "loophole" in the tax law. As Levin and Sherrod would have it, Facebook's tax deduction for using stock options to compensate executives – as opposed to any other form of compensation – would be essentially zero (that's probably a little dramatic on my part, but the point is the same); yet, Zuckerberg's tax liability when he exercises the options could be somewhere in the area of $3 billion.

When the Levin and Sherrod approach to taxation is compared to other forms of compensation to executives, rank and file employees, vendors and lenders, it makes no sense whatsoever. If the senators want to make stock options more costly to corporations than other forms of compensation, then so be it – but they should just come out and say so, and explain why it's a good idea.

But, most of what I have just written reprises my earlier post (and if you want even more background on the depressing politicis of the accounting question, see Jon Weil's article, here.) I'm covering this topic anew because Levin's Facebook IPO story raises some other interesting questions with implications for financial reporting.

My first question is this: If U.S. GAAP for stock compensation expense were based on the value realized upon exercise, just like the tax rules, how would that have affected Facebook's financial statements?

The strong implication of Levin's narrative is that the extra amount of expenses would have wiped out every dollar of Facebook's reported net income that it had ever 'earned.' On top of that, there could be other outstanding options held by Zuckerberg and other employees extending way down the organization, which are going to have the same effect on future reported net income.

Which brings me to my second question: For all practical purposes, could Zuckerberg be taking Facebook public at this point in time with no history of profitability, perhaps negative shareholders' equity, and perhaps no hopes for earnings for some for years to come?

My inclination is to say "no," but I can only speculate. So, I all answer that question with another question: Since the FASB's rules understate the economic cost of options granted to employees, did the FASB provide a perverse incentive to Facebook to grant more options (or at terms overly favorable) to employees than it should have?

If one accepts the maxim that "what gets mismeasured gets mismanaged," then the answer to that question should be "YES." The stock option problem lies not with the tax rules that eventually recognize the full cost of the options to shareholders, but with the financial reporting rules that allowed Facebook to grant options without recording their full cost.

Surely, the senators can see that different accounting rules would have wrought different compensation policies from Facebook. Senator Levin would not have had a story to tell and Mark Zuckerberg would be a few billion dollars poorer.

But, methinks that Facebook would still be Facebook.

* * * * * *

Footnote: It is my distinct pleasure to provide Senator Levin (and his staff) with yet another accounting lesson. The amount of expense to be reported by Facebook is not, as the senator claims, the exercise price of the options (i.e., 6 cents per share). Assuming that the options were issued without any intrinsic value, then their "grant-date present value" (i.e., the amount upon which periodic option expense is measured) could end up being more or less than 6 cents per share. Although this technical correction to Senator Levin's story it doesn't fundamentally change the message, it once again reveals a lack of understanding that makes one question if Senator Levin has an adequate grasp on the issues.

 

 

"Vulture" Capitalism, Accounting … and Mitt Romney?

Rabid conservative ideologues believe that everything transacted in a free-market, i.e., unfettered by government involvement or regulation, is by definition a good thing. I presume this is why Newt Gingrich acted like he was between a rock and a hard place when going negative on Mitt Romney's wealth, which was gained largely out of the purview of government regulators.

Gingrich has been desperately trying to besmirch Romney's reputation by any means possible (and I do mean any), but either he has been too lazy to collect facts or he has been unwilling to risk offending too many of the politically conservative oligarchs. Gingrich's excuse for vague assertions and conjectures seems to be that Bain Capital's affairs have been impenetrable.

Before going on, I want to be clear about what this post is not: a direct criticism of Mitt Romney's business dealings. Other than reading one Wikipedia article, I do not have a single fact as to what Romney did or did not do while at the investment firm he co-founded, Bain Capital. My objective is to provide a roadmap to the others for acquiring facts (if they exist) for legitimately evaluating Romney's past dealings. The signposts along that road are mostly failures in corporate governance, but as you might expect coming from yours truly, financial reporting has a little something to do with the story.

Corporate Governance and LBOs

It is well-known that Romney became rich in large part through acquisitions of controlling interests in hundreds of companies. Some of those companies were start-ups, but others were mature; they were transformed in one way or another such that Romney, his partners and the investors in their private investment fund reaped large profits from buying them up.

Many of these companies had been publicly traded before Bain's investment; these are the ones I will be focusing on. Typically, firms like Bain Capital obtain their interest in public companies as part of a "leveraged buyout" transaction, or "LBO." Very simply, an LBO is the acquisition of a company financed by a lot of debt. Sometimes, an LBO is referred to as a "bootstrap" transaction, because the acquiree's future cash flows (either from operations or sale of operating assets) are expected to be sufficient to pay down the debt and provide a healthy return to investors. Very often, and critically so, the top management of the acquiree takes an equity interest in the LBO. That can create a conflict of interest between one's personal ambitions and one's duty to shareholders, and the history of LBOs since the 1980s is replete with shareholder fleecings.  Here's my all-time favorite example:*

On Dec. 6, 1983, the senior management of Metromedia, offered shareholders $720 million in exchange for all of the outstanding shares. The offer was accompanied by a prospectus in which it was stated that by taking the company private, management could more effectively pursue a long-term growth strategy. The offer also followed a series of very negative press releases, which were clearly designed to drive down the share price, and consequently, the cost of the LBO.

Upon consummation of the LBO, John Kluge ended up holding 90% of Metromedia's equity, without having invested a single dollar. Within two years, Kluge realized over $4 billion from the outright sale of most of Metromedia's businesses (so much for that long-term growth strategy!).

In 1986, Forbes identified Kluge as the second richest American, behind only Sam Walton of Wal-Mart fame.

Not coincidentally, I believe, the shakedown of Metromedia's shareholders happened around the same time as Mitt Romney was offered the opportunity to become a venture capitalist – for Kluge's coup must certainly have whetted the appetites of many a high roller. LBOs began to lose their luster as a get-rich-quick scheme starting in the late 1980s, but the ethics still remained questionable. In a nutshell, here's why: If a public company could benefit from shouldering more debt, improving operations or selling assets, why should it take an LBO to get the job done?

The LBO Accounting Story

All of this would be a digression from the main theme of my blog – financial reporting – without this additional accounting twist. LBO accounting was controversial until FAS 141R, Business Combinations, became effective in 2009. Up until then, one school of thought was that if management continued to run the same company, and/or the LBO transaction was absorbed by a brand new legal entity and effected outside of the target company (i.e., through the purchase of shares from existing shareholders), the carrying amounts for the assets acquired in the LBO should not change. Under that view, companies that are taken private could do an IPO a few years later with the same basis for their assets; i.e., without the burden of additional depreciation or amortization expense, and with a higher return on assets.

Is window dressing important to LBO investors? Maybe not to all, but to some (perhaps Bain Capital) it must be. EITF 86-16, Carryover of Predecessor Cost in Leveraged Buyout Transactions and its successor, EITF 88-16, didn't just come from nothing. The special accounting for LBOs structured in just the right way must have been pushed by investors who really needed that type of accounting to make their deals work. Paul Kluge would not have been one (although Abe Briloff called him out for questionable accounting a few years earlier – and Metromedia's stock price dipped 25%), but as deals became more difficult (higher buyout prices and lower leverage), maybe Mitt Romney would have been willing to use an accounting trick to sweeten a deal. EITF 88-16 was finally nullified by FAS 141R, but that was not until 2009, ten years after Romney left Bain Capital for good to enter politics. In the meantime, aggressive use of EITF 88-16 clearly must have played a part in LBO transactions somewhere and somehow.

Whom Do You Trust: Mitt the Vulture or the Newt the Dodo Bird?

Maybe Bain Capital's LBO transactions were pure as the driven rain. I don't know, and all I'm doing is providing a line of inquiry for those like Newt who seem to need a roadmap to validly question whether some or all of Romney's considerable wealth was fairly or ill-gotten. At the very least, those looking to put Mitt Romney's business career under a microscope should be asking whether the equivalent of Bain's brains and money could have been had without: booting shareholders out first; or paying such princely sums to Romney and his partners; or by giving preferential accounting treatment for LBOs. Creative destruction may be essential to economic growth, but vulture capitalism is not.

I don't buy Gingrich's excuse for not having facts to support his claims. There are always two sides to every transaction. Surely, if they exist, disgruntled counterparties and abused former employees of LBO targets should be all too willing to "swift boat" Romney. Come to think of it, since no one has yet to come forward, then maybe he's clean.

I won't speculate any further whether there are skeletons in Romney's LBO closet, but keep in mind that LBO transactions are rife with potential for conflicts of interest. For example, management may sell its own shareholders down the river for a quick buck; board members don't want to become too obstructive to their friends in management; investment advisers with a stake in the transaction may offer bogus "fairness opinions"; and auditors may remain silent even with full knowledge that a fleecing is about to take place. All of this could be happening as an LBO investor writes checks to facilitators and gives them encouraging pats on the back.

If Romney is complicit in a Kluge-type scheme to any degree, then a part of his fortune would have been built not from taking a fair share of value added through creative destruction, but through vulture capitalism – shareholder fleecing and economically unjustified upheaval of the lives of employees, their families and other innocent bystanders.

Ultimately, voters have a right to know.

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 *Adapted from two articles by Benjamin Stein in Barron's, "Where Are the Shareholders' Yachts: But John Kluge Pockets Billions from Metromedia's LBO" (August, 18, 1986); "Shooting Fish in a Barrel: Why Management Always Makes a Bundle in an LBO" (January 12, 1987).

Repo Accounting: After Lehman, another Debacle was Just a Matter of Time

Last January, as the FASB proposed closing that 'Lehman loophole' in repo accounting while leaving three other loopy conditions to be met for "sale accounting" intact, I predicted that it would just be a matter of time for history to repeat itself, albeit through exploitation of some other gap in rules-based GAAP. As it turned out, it took less than a year for another major debacle to occur. This is how the Grumpy Old Accountants describe what happened at MF Global:

"MF Global structured the repo so that it matured when the [European sovereign] bonds [being transferred] matured. The assertion is that the firm doesn't control the debt instrument during the repo period, and when the repo matures, the firm will not regain control of the instrument because it matures on that date. Nice try.

MF Global in fact did not relinquish control of the securities. If the firm had relinquished control in reality, then it would not have received those coupons [on the bonds]."

Just as I had concluded, Grumpy Old Accountants (namely, academics Ed Ketz and Anthony Catanach) find that the FASB is not doing its job. "It should have fixed repo accounting ages ago," and they endorsed my suggested change to sale accounting whenever it applied:

The following procedures would apply to securities for which legal ownership (as opposed to 'effective control') has transferred:

1. At the inception of the agreement, a transferor would recognize an asset for the cash received and derecognize the securities transferred. Any difference between these two amounts would preferably be reflected on the balance sheet as a change in shareholders' equity through net income.
2. To recognize the commitment to repurchase the transferred securities, a receivable for the future return of the transferred securities would be recognized at its fair value; and a payable would be recognized at its fair value for the price to be paid for the return of the transferred securities. In contrast to existing accounting rules, these two amounts must be presented "gross"— i.e., they may not be offset. And again, any difference between these two amounts would be reflected on the balance sheet as a change in shareholders' equity through net income.

Although I still like my solution, I am well aware that others dislike violations of the general rule of not recognizing assets and liabilities related to contracts for which mutual performance must occur – i.e., executory contracts. There are exceptions (capital lease accounting most prominently), but the FASB could spend its time going around in circles debating whether this particular executory contract merits a treatment that is inconsistent with other executory contracts, where to draw the line, etcetera, etcetera.

So, I'll make it even easier for the FASB. It can even keep that silly "effective control" thing if it wants; however, if a transferor were to apply sale accounting for a repo, it must separately and prominently disclose the fair values of the right to receive the security and the obligation to pay cash. With such disclosures present, not even an understaffed government regulator like the SEC could miss the risk implications of an obligation to pay a fixed amount of cash for a security whose future value is uncertain. And, any analyst could easily make pro forma adjustments to published financial statements as it suits one's own views and preferences.

For the most part, GAAP doesn't do a very good job of providing information about risk; and I am not aware that the SEC's requirements to provide qualitative and quantitative information about market risks (see Reg. S-K, Item 305) are very helpful, either. Which leads me to a related suggestion: to require separate fair value information on both the receivable and payable legs of all financial derivatives. Just a very few numbers would be worth much more than thousands of words worth of sleep-inducing narrative disclosures that, even when provided in good faith, are far too subjective and lacking in comparability across companies or time.

In short, the disclosures I am suggesting would be super straightforward, highly informative, and easily enforceable. Consequently, for every future derivatives-based accounting scandal, I'll be asking whether fair value disclosures of the asset and liability legs could have prevented, or mitigated investors' losses and still further erosion in the public's confidence in our capital markets and financial institutions.

 

I'm Not the Only One Dissing the SEC's IFRS Fixation

Every time I write a post, I might receive a couple of non-spam comments, and perhaps a few more private emails intended for my eyes only. Most of the feedback is positive, and even encouraging. Nonetheless, I am by nature particularly sensitive to negative feedback, even when delivered in a kindly and constructive manner.

For example, Edith Orenstein thinks I jumped the gun with my assertion that the "fix is in," on the forthcoming SEC Roundtable on IFRS; and Lane suggested that my arguments lack force when I predicted that some panelists would be shills. These comments came even prior to my most irrascible rant on the Roundtable after it took place. In some ways, this post is a response to Edith and Lane: I know that my comments are often unkind and liberally dosed with irreverence and sarcasm; but in my defense, I am not the only one out there letting their frustration with the SEC's IFRS fixation hang out.  Consequently, even in my most untethered moments, it feels kinda OK to know that I'm in pretty decent company:*

Lynn Turner, a former SEC chief accountant no less, circulated this email bearing the incendiary subject line "Stacked Deck":

"I find it interesting that so many credit rating agencies are given slots at the SEC IFRS roundtable when they were the very ones who so shafted investors. And Jonas who was at one of them, now at Morgan Stanley, and who was head of the AA national office is another one of the participants.

Take a look at the panelists on the small-company panel. Bank of the West isn't a public company – it's owned by BNP Paribas. Cuisine Solutions has a subsidiary in France – sort of unusual for a small U.S. company. Viropharma has a European unit. Tandy Leather has operations in Canada and the UK. Are you seeing a pattern here? They specifically aren't having as panelists the kind of strictly domestic small public company that wouldn't benefit from IFRS."

And in a subsequent email:

"The SEC so stacked this deck it is beyond one's imagination as to why they would expect anyone outside their 4 walls would see this as anything short of the typical Washington DC contrived outcome."

Jack Ciesielski, former member of FASAC, AcSEC, EITF and author of one of the most highly respected publications for financial statement analysts, described the upcoming Roundtable as a "railroad job." And he also wrote a must-read comment letter on the SEC staff's paper, "Exploring a Possible Method of Incorporation." Like Gaylen Hansen's remarks from the Roundtable, all of Jack's criticisms are quite devastating, but the one from Jack that resonates with me for its originality and the vividness of the example is the following:

"If the FASB is barred from starting projects independently of the IASB, how are American investors best served? There could be financial reporting issues that are unique to our country, that would never be addressed by the IASB - simply because they are not a problem in the rest of the world.

An example may help make the point. In the United States, many … are troubled by what they consider to be excessive executive compensation. There is only a limited amount of information available annually regarding executive compensation. More comprehensive information about all of a firm's human capital costs (not just executives' compensation), directly displayed in financial statements on a quarterly basis, would be useful for investors to help them assess the value of pay packages on which they vote annually. … There's no cohesive model or set of disclosures for reporting pay information. What gets measured, gets managed - and since there's not much reporting of pay information to investors, it's likely not to be managed too well.

It's a uniquely American problem, not shared elsewhere in the world. The FASB should undertake a project for improving investor information in this area - but it would be barred from doing so under condorsement, unless the IASB deemed it necessary. That's not likely to happen unless it became a problem elsewhere in the world. Is it fair to ask American investors to wait until an American issue that may be resolved by better accounting and disclosure is a problem in the rest of the world? In a word: No." [ first line bold in original, bold italics supplied]

Professors Ed Ketz and Anthony Catanach (Grumpy Old Accountants blog) evidence even less restraint in venting their frustration than yours truly. The title of their latest blog post, "IFRS is for Criminals" is more than sufficient evidence for that.

Floyd Norris, NYT columnist, trenchantly observed that, if the SEC were to follow through on its "condorsement" idea, many "flavors" of accounting would be the result for many years – if not indefinitely. The drive for IFRS to eventually replace U.S. GAAP increasingly appears to be coming from large companies who would like the SEC to give them the option to report using IFRS, just like many of their counterparts overseas.

But, I enjoyed Floyd's column the most for his one-liner response to the latest lobbying by IASB chair Hans Hoogervorst for the EU to endorse its latest pronouncement on the accounting for loan losses. Hoogervorst said straight out that the rule should appeal to the European Commission because it gives banks the free option to ignore economic reality, e.g., Greek bonds trading at junk debt levels:

"But it may not appeal as much to those who rely on financial statements, and would prefer to know when a bank's loans go bad. As a sales pitch, 'Adopt our rules and you won't have any losses' does not sound like a promotion for a superior set of accounting standards." [emphasis supplied]

Gosh, I wish I had written that!

Some say that the same sorts of political machinations are at work on U.S. GAAP. Even granting that point today (which I don't), imagine how things will look if more countried created an EU-like infrastructure for the purpose of lobbying the IASB for just the right IFRS standard to incorporate into its own system. The EU, the US, China, Japan and a hundred other smaller economies would be 'on board' with IFRS, but the IASB chair's head would have to be on a swivel in order to fend off each and every attack from increasing numbers of 'incoporators', 'endorsers', 'advisory groups', etc. The IASB will, in effect, devolve to something awfully akin to its early beginnings when the IASC (the IASB's predecessor) worked as a 90-person committee.

The only "standards" or "principles" back then were that there were none. A new era of balkanized accounting jurisdictions could put the IASB right back to where it started.

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

*Some of the comments made were in private correspondence with me. In every case I received permission to reproduce them here.

SEC IFRS Roundtable Agenda and Panelists are Announced: Even Worse News than I Expected

This is a short follow-up to yesterday's post on the upcoming SEC Roundtable on International Financial Reporting Standards.

As I feared, the agenda is not even on the same planet as the core questions, indicating ever more strongly that the fix is in. Of the panelists, I know two of them (good things), and know a little something about one other (a bad thing).

Of the two panelists I know, the more outspoken is Gaylen Hansen, director at large of the National Association of State Boards of Accountancy (NASBA) and partner at accounting firm EKS&H. Gaylen was the first, even before the SEC, to go public with an analysis of the constituent feedback from the SEC's Roadmap proposal. He did it at a NASBA convention, and I wrote about it here:

"The problem for … 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." [Just to be clear, I am quoting myself.]

I'm guessing that the SEC felt they had no choice but to ask NASBA to provide a panelist, and bless NASBA's little hearts, they picked Gaylen. I know he has a lot to say about IFRS, and for me, the only drama remaining is whether he will actually be given a chance to say it.

I Don't Know this Guy, But I Think I Know What He's Going to Say…

The panelist I know of by reputation only is Bill Yeates, partner at Hein & Associates. The SEC's brief description of him doesn't mention that he is a past member of both the SEC Regulations and Professional Prace Executive Committees for the Center for Audit Quality (CAQ). For that reason alone, I suspect that he was handpicked by the AICPA, and will as a matter of course shill for them.

Mr. Yeates is on the "smaller public companies" panel, and I find it amazing that the SEC refuses to recognize that CPAs have a built-in conflict of interest on any IFRS policy question. Moreover, regardless of the size of the issuer, the SEC should be focusing on the financial statement user, and not the financial statement supplier. How are these panelists supposed to tell us about "…financial statement users and their needs," as listed in the agenda, if not one is actually a financial statement user?

The Token Investor Issues

Here are the issues that the first panel, entitled "Investor Understanding and Knowledge of IFRS" are supposed to address:

• U.S. investors' current knowledge of IFRS and preparedness for potential incorporation
• How and when U.S. investors educate themselves on changes in accounting standards
• Extent, logistics, and timing necessary to undertake changes to improve investor understanding of IFRS
• Potential methods of incorporation

These topics aren't even on the same planet with the core questions that the SEC has been avoiding for years (I know, I'm repeating myself):

• Do investors perceive that IFRS gives them higher quality information than U.S. GAAP?
• Is there any hope that financial statements will become more comparable across issuers over time by continuing to work with IFRS?

And, please tell me how this handpicked panel, which purportedly can represent investors' interests in the IFRS policy decision, is competent to evaluate the "potential methods of incorporation"?

* * * * * * *

And, tell me again why, two years after the Roadmap proposal's comment letters were tabulated and analyzed we are still wasting time on this? It should be said that a couple of commenters to my blog post on Gaylen's analysis found fault because one form or another of non-response bias could have skewed the results. There is a lot of validity to that, but there are ways to investigate the degree to which non-response bias accounted for the findings. The SEC has had two years to follow up on the comments from the Roadmap proposal, but of course, they have done nothing – because, I'm thinking they were thinking that they couldn't control the results.

A "roundtable," on the other hand, can be controlled. Even though it may not be possible to handpick each panelist, a watered-down agenda with very little time for each panelist to say their peace is likely to do the trick.

An earlier version of this post incorrectly stated that Bill Yeates is a CAQ board member.  I regret the error and apologize to Mr. Yeates.

The FASB Could Rescue the Financial System – But It Won't

If you want to understand the causes of the financial crisis from 25 pages instead of the 600 pages burped up by the FCIC, then read this: Understanding the Subprime Financial Crisis, by Duke Law professor Steven L. Schwarcz. I also like this paper very much because the final section cogently reduces the oft-recited litany of a cascading series of value-destroying events to four fundamental vulnerabilities. Schwarcz's premise is that awareness of these vulnerabilities provides a framework for thinking about what should be done to avoid future crises.

My premise is that much of what can and should be done involves radical reform of accounting standards. That's why I am disappointed that both the Schwarcz paper and the FCIC report (albeit Schwarcz slightly less so) fail to discuss to any degree how politically-jiggered accounting standards facilitated the financial crisis; and critically, how simpler yet more robust standards could make the future much more secure. Notwithstanding this shortcoming, Schwarcz's paper at least provides little ole me with a foundation for discussing how improvements to financial reporting could be the most significant reform we undertake in response to the third financial crisis in twenty years.

Let's take Schwarcz's list of vulnerabilities one at a time:

Conflicts of Interest

This first category, conflicts, has a number of dimensions, such as information asymmetry issues between mortgage lenders and investors in securitized mortgages. These would seem to be curable by disclosure reforms, and the SEC has been focusing on replacing reliance on credit rating agencies with enhanced disclosures. However, Schwarcz sees another problem, "super large" compensation payouts, to be less tractable:

"[If] an individual's compensation, even if it were to be fully adjusted downward [i.e., clawed back or contingently paid over time], still enables that individual to be financially independent of the firm, then that individual's incentives will not necessarily be aligned with the firm's incentives." [p. 562]

To my view, super large compensation starts at the top, and works its way down. There can be little argument that the accounting, in and of itself, for stock options granted to executives has contributed to the financial crisis, and subsequent events strongly indicate that no reasoned solution has been proposed. So, here's mine.

Relatively recent accounting rules require that at least some of the economic cost of compensation must hit the income statement, but the grant-date measurement rules reveal only the tip of massive payouts to bank executives. Stated another way, the rules provide that "super large" payouts to executives are never matched by super large expense recognition.

The only way for this matching to occur is to treat stock options just like any other derivative written by a company. This would require updating measurements through exercise or expiration, and thereby measuring compensation cost by the actual amount of value transferred. Moreover, exercise date accounting would dovetail very well with the new SEC shareholder "say on pay" rules and the "Compensation Discussion and Analysis" disclosures in proxy statements. Shareholders have a right to know how a particular compensation scheme can be expected to align management's interests with the interests of shareholders when managers have been made financially independent from the firm.

Investor Complacency

"Complacency is a more difficult category because the government cannot change human nature—although it can try to affect behavior." [p. 563]

Complacency exists in part because the certain cost of being anything more than passive is not expected to be offset by the uncertain benefits. The vast majority of investors choose to place their trust in the integrity of the financial reporting regulators – to have put in place a system that clearly signals when financial performance has lagged, or that excessive risks have been taken.

That the accounting standard setters have utterly failed to live up to the trust that investors have placed in them is the overarching theme of this blog. Only the notion of investor complacency can explain why investors have not yet stormed the FASB's headquarters, much as Egyptians demonstrated in Tahriri Square to protest a plutocracy operating behind the façade of democracy and due process.

I have no suggestions for altering the calculus leading to consistent investor complacency. The only solution is for regulators, most especially accounting standard setters, to embrace the reality that investors will not tend to exercise their right to be heard, rather than to exploit that vulnerability. For example, accounting standards should acknowledge that investor preferences dictate that disclosure – even under the best possible circumstances – cannot be an adequate substitute for financial statement recognition. They should also acknowledge that due process is clearly not working even though thousands of comments against a proposed standard have been received from issuers, largely with the objective of drowing out those few investors who care to be heard. 

Complexity of the Modern Financial System

"[T]hings are just too complex to understand. This manifests itself, for example, in the difficulty of achieving transparent disclosure for complicated securities and also in the difficulty of market participants to learn the financial condition of their counterparties (due, for example, to their entering into credit-default swaps). … For the failure of disclosure, investors can partly address this failure by demanding more and better disclosure, including disclosure of contingent liabilities."

I wish Schwarcz and others would also acknowledge that disclosure failures and complexity feed on themselves. To a large extent, financial instruments are complex because they were engineered to be eligible for a particular accounting treatment favored by management: executive stock options, repos, securitizations, credit default swaps – the list can go on forever.

Just imagine how financial reporting would be improved if current values of investments were stated on the balance sheet, all legal rights and obligations were recognized on the balance sheet, and the asset components of contracts (derivatives and otherwise) were presented separately from their liability components. Not only would financial analysis become far less complex due to the add transparency of financial statements, but the financial arrangements themselves would be less complex.

Systemic Risk of Externalities

"[E]ven if [all individual] market participants fully understand that incurring certain risks may contribute to systemic risk, they will not be motivated, absent regulation, to internalize those risks. … [T]herefore, the solution to systemic risk is to impose regulation that internalizes those externalities." [p. 566]

Once again, the accounting standards I have mentioned above could come to the rescue. Mainly, the prudential regulators would have more objective and reliable (albeit extremely conservative) measures of capital adequacy. Though other forms of regulation would still be necessary, we could actually find that we might need fewer regulations than exist currently.

The most generous interpretation of the post-crisis state of financial reporting is that contributions from thinkers like Steven Schwarcz— even though he has little to say about accounting itself—can help accounting standard setters identify opportunities to enhance the safety of capital markets through improved accounting standards.

If only it were so. While the FASB continues to fiddle with convergence ad nauseum, Rome will surely burn ... again.

GM's Future IPO: Whom Can Investors Trust?

Not only does General Motors' CEO, Edward E. Whitacre Jr., want to take GM public ASAP, he is asking the federal government to sell its $50 billion (!) stake at the same time. That's all well and good, but I have two concerns: (1) whether the SEC will, or can possibly be, an effective gatekeeper of a GM IPO; and (2) whether the contemplated timing (before the end of 2010) would be in the best interests of investors.

Concern #1: We Have Seen the Issuer, and It Is U. S.

A cornerstone of financial reporting regulation in the U.S. is the requirement that an offering of securities to the public must be preceded by a registration statement. This is the means by which required disclosures become public, while at the same time providing the SEC with all the time it needs (usually around 30 days) to review the disclosures for compliance with its rules.

Other jurisdictions claim to have similar protections for its investors, but nothing matches the thoroughness of the SEC's review of prospective IPOs. It is not uncommon for an IPO registration statement to generate dozens of comments, each one of which the issuer must address to the SEC's satisfaction before it will permit the offering to go forward.

The IPO review process isn't perfect, and the SEC in no way guarantees that they caught every "deficiency" in a document they reviewed. Yet, the SEC's reputation as the most active and effective securities regulator in the world is derived in large part from how seriously they take this most basic aspect of their work. But, the imminent IPO registration statement filing by GM could put that reputation to the test—not so much because of the record size of the transaction, but because the issuer and the regulator are one and the same.

Please forgive me for stating the obvious: the federal government holds a 61% of the outstanding shares of GM; GM's disclosures are expected to affect the offering price; and, the government has a direct and significant interest in the offering price. There is just no getting around the fact that the issuer is the government, and that selfsame government will be reviewing what is effectively the sales brochure for the offering for truth in advertising.

I would venture to say that the circumstances of the GM pose a singular challenge to the SEC, and they could be receiving the registration statement in just a few months.  To start the conversation on it can most appropriately defray itsconflict of interests, I humbly submit these ideas for the SEC's consideration:

Make the review process fully transparent.

Comments on registration statements and issuer responses are not normally made public until long after the offering has taken place. As a general matter, some could argue that confidential treatment of "deficiency letters" unnecessarily coddles issuers; but setting that cavil aside, nothing prevents the SEC from making an exception to its own policies. For example, the SEC could keep its initial comment letter confidential until GM provides its written responses. Concurrent with GM's response, both letters could be posted to the SEC's website.

Outsource the registration statement review to an independent third party.

There must be dozens of former SEC staffers in private practice who are qualified and willing to review GM's registration statement. The SEC could appoint, after a transparent selection process, a few individuals from among their alumni to serve on an independent committee whose sole responsibilities would be to review GM's registration statement, and ultimately to draft the comment letter. After appointing the committee, the SEC should recuse itself from the decision to allow the registration statement to become effective.

Review the reviewer

The SEC could hire one accountant and one attorney to oversee and report on the SEC's review of GM. Recusal, as described above, would be preferable, but an additional layer of review from an independent source is more acceptable than business as usual.

Of course, the SEC could choose to nothing special whatsoever -- i.e., proceed as if GM were like every other issuer. But, that would be a denial of reality, something which the SEC has recently become too prone to do (see Bernie Madoff, International Financial Reporting Standards, Bear Stearns, Pequod Capital and too many more). It would be acting as if a conflict between investor protection and the financial interest of the government doesn't even exist—yet that's what I am afraid will happen in the absent calls from investor groups and (gasp) politicians to undertake a singular review process that would be beyond reproach. When the government plays the issuer in the largest IPO in history, the safeguards investors are entitled to require even more reliability than deepwater blowout preventers.

Issue #2: If Timing Is Everything, Then Somebody May Be Getting Fleeced

GM seems to be poised to base its registration statement on its earnings from the third quarter of its current fiscal year. It is not uncommon for a company to time its public offering to follow on the heels of a couple of good fiscal quarters.  Under even normal circumstances, investors would have two concerns with that kind of timing: (1) whether anything like that gangbuster last six months or so can be sustained over the long term, and (2), whether the reported profits of an audited "stub" period will hold up to the scrutiny of the independent auditors.

I know that it has been the government's policy to let the management of GM run things, but after GM gets its money, Mr. Whitacre plans to take the next stagecoach out of Dodge (I noticed the pun only on the third reading). In the case of a restatement or other material error in the registration statement, Whitacre won't be around to take full responsibility for misleading investors, and the new gang in charge will be pointing fingers right and left.

For these reasons, the government needs to dictate the timing of the offering. First and foremost, it must assure that the latest balance sheet and income statement included in the registration statement will be audited (Note: interim period financial statements in the registration statement don't have to be audited under SEC rules).

Second, the CEO who signs that registration statement has to be on the hot seat for at least a year after the IPO. And, third, despite Whitacre's express wishes, the federal government needs to keep its own shares for another year after the IPO takes place. If investors are going to lose money because the IPO was mispriced, the government shouldn't be adding its shares to the public float until GM's share price is determined through a sufficient period of secondary market trading.

I can already hear in my head what the response of GM's management and IPO promoters will be: "Look, we're the ones that brought GM back from the brink. You can trust us."

Right.

FASB Alumnus Trashes GAAP (and IFRS)

When I started my blog almost exactly 3 years ago now, my opening strategy was to work down a rather limited personal inventory of pet peeves. I wanted to stay above the fray, but that proved impossible. I soon became hopelessly drawn to commenting on the helter-skelter stampede of recent developments driven by the Big Four's IFRS putsch and the undeniable role that lousy accounting standards played in the financial debacles of 2007 and beyond. 

But, who really cares what I think?  I suspect that the folks being paid the big bucks to make the tough calls on accounting standards don't pay a lot of attention to to the likes of Tom Whatshisname, even were I to announce that the sky is falling. But, I don't take it personally. Over the past 40 years, any PhD not drawing a salary from the Big Four has been viewed with more suspicion than respect by the standard setting establishment.

I mention all of this now, because there is a new voice, whose credibility and qualifications cannot be so easily dismissed.  That voice belongs to FASB alumnus David Mosso, who has written an 80-page monograph entitled Early Warning and Quick Response: Accounting in the Twenty-First Century).  If you don't want to believe me, take it from him: GAAP is broken.

Mosso is not just some average pedant. He has pretty much done and seen it all when it comes to accounting standards setting, most significantly having spent nearly twenty years at the FASB, and having been a board member for ten of them:

"I spent three decades in helping to create the accounting mess called generally accepted accounting principles, or GAAP. This book is an attempt to make amends." (page 1, italics supplied)

"Eighty years of tinkering [with a broken accounting model] has not done the job. … In the case of business failures, the company's auditors are usually the scapegoats, but I suspect that accounting standards are often more, or at least equally, at fault." (page 78, italics supplied)

I'm not trying to promote Mosso to oracle status, but coming from him—as opposed to whatshisnames like me—this should been seen more as an indictment than merely opinion. (By the way: just to be sure he wasn't just trashing GAAP, I asked David via email what he thought of GAAP/IFRS convergence. He replied that it was like the collision of two garbage trucks.)

Mosso's book has three principle themes:

1. Financial reporting is a vital function; however, the politicization of standard setting has been far more harmful than beneficial. Words like "junk," "trash," and "garbage" permeate the references to current GAAP.
2. GAAP must be fundamentally changed. Mosso's proposed system of accounting rules consists of little more than a few principles, which together comprise his "Wealth Measurement Model" (WMM). The gist of that model is to recognize "all" the assets and liabilities of an entity and to measure them at fair value, which apparently out of convenience is specified to be in accordance with existing FAS 157. Mosso claims that the comprehensive nature of WMM makes it capable of generating timely signals of looming problems to both investors and policy makers.
3. Upon implementation of the Wealth Measurement Model, subsequent accounting standard setting could be limited to a sort of rapid-response version of the Emerging Issues Task Force for addressing implementation issues arising out of innovations in business practices and new technologies.

I don't have much to say about the third theme, because it's not a topic that I spend much time thinking about. I do acknowledge, however, that the current standard-setting system is seriously dysfunctional. And, I can't resist pointing to Mosso's contention that accounting standards should be run by academics, because "…accounting professors are the only group with the untainted standing to represent the public interest." Read, all ye good people, what this brilliant and eloquent man has thusly writ!

As to the pile of trash that GAAP has come to be (#2, above), I licked my chops when in the first chapter Mosso broadly hinted that his readers would receive the down low skinny on those back room machinations, which led to the accounting standards to bring him the most shame. However, there was absolutely none of that in the book. Mosso's only specific mea culpa was this tiny little snippet:

"When standard setting was formalized, standard setters seem to have taken the existing equity classification of [preferred stock, stock purchase warrants and stock compensation options] for granted without much scrutiny. I acknowledge that I did not challenge the conventional classifications when the conceptual framework was under development."

To his significant credit, however, Mosso may be the first real insider to broach the topic of standard setting dysfunctionality so comprehensively, even though I feel more than a little let down by his refusal to dish. Since Mosso is asking his readers to consider proposed solutions from an admitted creator of the problems themselves, I feel entitled to more of something like this:

"We wrongly promulgated X (and I voted for it) because of pressure from Y. The resulting harm was Z1, Z2 and Z3.

I gag every time I think of the quantities of toxic waste that my innocent son and his babe-in-the-woods peers are force-fed from their 1000+-page "intermediate accounting" textbooks. It would be nice if at least one of the authors of the master cookbook strongly advised students that many grains of salt should be added before consuming.

The Wealth Measurement Model

There is a great deal to admire about the WMM. In particular, I strongly support limiting owners' equity to basic ownership interests, and throwing goodwill and deferred taxes onto the trash heap.

But, I do have two important concerns; in regard to how Mosso would measure assets and liabilities, I believe he is not being ambitious enough; and in regard to which assets and liabilities Mosso would recognize, he is far too ambitious.

The Measurement Issues—Although Mosso states that assets and liabilities should be measured at their fair values, I suspect that deep down, he realizes that replacement cost is the attribute of an asset that corresponds to "wealth." I draw my inference of Mosso's true views from Chapter 5, wherein he discusses the insights to be derived from comparisons of the market value of a firm's equity to the replacement cost of its net assets – i.e., a variant of Tobin's Q ratio. Mosso's analysis clearly indicates his awareness that "wealth" embodied in productive assets like machinery is not correctly measured by the current amount for which the machinery could be sold, but for how much it would cost to replace its productive capacity. So, I find it slightly ironic that Mosso condemns the politics of standard setting, but himself seeks a political compromise with the hope of persuading proponents of fair value to embrace his WMM.

The Recognition Issues—These are an even bigger concern to me than the choice of fair value over replacement cost. Mosso contends that accounting standards can be written such that "all" assets and liabilities could be found on the balance sheet. I'll admit that the possibility is tantalizing, because it would eliminate off-balance sheet financing, and it would also transform what is now merely a "balance sheet" to a true "statement of financial position." Unfortunately, Mosso's vision is unrealistic; and here's a couple of examples to illustrate why:

• A competitor's misfortune provides an opening for an entity to introduce a new product. Such an opportunity is what is known as a "real option." An accounting definition of "asset" that would comprehend those circumstances would be far too broad to be of practical use.
• Without going into too much detail here, Mosso would require the recognition of "constructive" liabilities (even though that's not the term he uses), and for reasons I explain here, I would not support that.

Therefore, the set of assets and liabilities that would be eligible for recognition needs to be bounded in a manner that can be consistently applied and audited. For me, legal rights and obligations form natural and convenient boundaries.  It has been my position that assets and liabilities recognized should be limited to legal rights of ownership, rights of use, and rights to receive assets in the future.

A Final Thought

When a member of the guild of royal sausage makers issues a health advisory, we need to find something else to eat. David Mosso's new recipe does not perfectly suit my tastes, but it's definitely restaurant quality.

FASB Could Have Easily Stopped the Repo Accounting Games: They Should Explain Why They Haven't

On April 19^th, FASB Chair Robert Herz submitted a letter to the House Financial Services Committee, explaining the accounting standards that applied to Lehman's repo transactions. In desperate hope that the Committee will also ask whether and how those repo accounting rules could be improved, I decided to follow the FASB's letter to the Committee with one of my own. I haven't sent it yet, but the gist of the latest draft is here in this post. I hope you will send me your comments, suggestions, hisses, groans, etc.

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

The purpose of this letter is to supplement the information provided to you by Robert Herz, FASB chair, in his letter of April 19^th regarding, among other things, the FASB's accounting requirements applicable to repurchase (repo) agreements. As I will describe further below, I believe the committee should be aware that FASB rules addressing the accounting for repo transactions are based on needlessly complex and subjective criteria, which apparently gave license to the machinations that Lehman Brother Holdings Inc. (Lehman) allegedly engaged in for the purpose of removing liabilities off period-end balance sheets.

I would also like the Committee to be aware of the fact that the accounting rules governing repo agreements need not be based on criteria that invite exploitation by managers who care little about fair presentation of financial information to investors. On the contrary, it would be a straightforward matter for the FASB to promulgate rules governing the accounting for repo agreements that are simple, transparent, representationally faithful, relevant to investors, useful to prudential regulators, and would not provide an open invitation for abuse.

The FASB Should Amend Its Repo Accounting Rules

I am proposing for the Committee's consideration a different approach to repo accounting, the first requirement of which is that transferred securities would be measured at fair value. [Note 1] In fact, the FASB has recently announced its intention to require that virtually all financial assets should be measured at fair value.

Second, the following procedures would apply to securities for which ownership has transferred:

1. At the inception of the agreement, a transferor would recognize an asset for the cash received and derecognize the securities transferred. Any difference between these two amounts would be reflected on the balance sheet as a change in shareholders' equity through net income. [Note 2]
2. To recognize the commitment to repurchase the transferred securities, a receivable for the future return of the transferred securities would be recognized at its fair value; and a payable would be recognized at its fair value for the price to be paid for the return of the transferred securities. In contrast to existing accounting rules, these two amounts must be presented "gross"— i.e., they may not be offset. And again, any difference betwee these two amounts would be reflected on the balance sheet as a change in shareholders' equity through net income.

 

If ownership of the securities does not change per the terms of the repo agreement, then the initial transaction would again recognize the cash receipt, and also a liability to pay it back. The transferred securities would be unaffected. Ultimately the difference between the amount initially recorded as the liability and the cash paid to the counterparty in the repo transaction will be reflected as an increase or decrease to shareholders' equity through net income.

Comparing My Proposal to Existing Accounting Rules

I hope that the Committee will consider whether the standards of accounting that I have proposed are reasonable and would prevent abusive financial reporting practices. In my opinion, they are.

First, unlike the current rules, my proposal is principles-based. The accounting for a repo agreement should reflect without undue effort, given the sophistication of the parties involved, reflect the fair value of each party's obligations and rights.

Second, it appears that the complexity of the Lehman Repo 105 and 108 transactions were not driven by financial considerations, but only by an intent to qualify them for sale accounting treatment. One may debate whether or not Lehman's accounting for its repo agreements complied with existing accounting rules, and like Mr. Herz, I am unable to express an opinion on that without additional information. However, it is inarguable that Lehman's machinations, which were consistently timed to take place near the end of each fiscal quarter, had no other business purpose except for obtaining a particular accounting result. If the accounting rules I am proposing had been in effect, such machinations would have been ineffective for meeting Lehman's apparent financial reporting objectives.

Third, my proposal adds transparency through the requirement to separately report the fair values of assets and liabilities. As a matter of accounting policy, gross presentation should be required when net presentation would be misleading. For example, existing lease accounting rules require that some leases (so-called "capital leases") must be accounted for by the lessee by recognizing representing a right of use of the leased asset, and an obligation for future payments to the lessor. For reasons very similar to the issues raised by Lehman's accounting for repo agreements, the FASB has expressed its intention to require that all leases should be presented on a gross basis, even though the receivable and the liability are with the same counterparty. [Note 3]

Fourth, as Mr. Herz has explained in his letter, the accounting for repo agreements hinges on whether the transferor of securities has maintained "effective control," a condition which is difficult to describe, much less objectively determine. An "ownership" criteria, on the other hand refers to a legal standard, and use of that standard would have thwarted the alleged abuses of repo accounting by Lehman and any other reporting entity.

The Committee Should Investigate Whether the FASB is Responsible for Economic Damages Caused by Its Inadequate Repo Accounting Rules

As Mr. Herz explained, Lehman construed (and their auditor apparently agreed) existing repo accounting rules to permit them to apply sale accounting treatment to its Repo 105 and 108 transactions. As a result, Lehman was able to reduce its on-balance sheet liabilities; because sale accounting treatment calls for the transferred securities to be derecognized from Lehman's balance sheet, and the cash proceeds from transferring the securities was used to settle other liabilities. Under the accounting rules I have proposed, the liability shifting that Lehman had engaged in would not have been possible. This is because the net balance sheet effect, which is to increase assets for the cash received, and to increase liabilities for the obligation to pay cash to the counterparty, does not depend on whether the repo arrangement results in a change in ownership of the transferred securities.

More generally, the Committee should consider whether the existing FASB rules are appropriate for any repo arrangement. In my opinion, they are not. The FASB's rules are based on the simplistic assumption that any repo can be classified, and consequently accounted for, as either a secured borrowing, or a sale of financial instruments; and that a series of subjective criteria will reliably distinguish between these two species of repos. The result of the FASB's approach has predictably been that a small variation in contract language could tip the scales one way or the other toward radically different accounting treatments and portrayals of financial risk and solvency.

Moreover, the FASB should have known that its rules-based approach to accounting for repo agreements would be abused by some issuers to defeat both fair presentation to investors and to corrupt the inputs to capital adequacy calculations relied on by prudential regulators.

I hope that the Committee will see fit to investigate the issue of the FASB's responsibility further. While Mr. Herz did state in his letter that most repo agreements called for treatment as secured borrowings, the Lehman case has made the general public aware that the availability of sales accounting treatment may have contributed in a significant way to the instability of financial institutions, which in turn led to government bailouts of those deemed "too-big-to-fail."

The Committee should ask Mr. Herz whether the abuses of repo accounting that have occurred should have been foreseen by the FASB, and whether he believes that the FASB shares responsibility for the financial crisis that plunged the federal government into further debt, and the economy into recession.

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

Note 1: Defining and measuring "fair value" are matters of considerable controversy. For the purpose of these comments, however, it is not necessary to consider this issue beyond acknowledgement that "fair value" connotes any one of various approaches for reporting a current economic value for an asset.

Note 2: Other treatments of the difference are possible, and I do not recommend that the Committee focus on that issue at this time.

Note 3: There is also a strong argument to be made for gross presentation of many other financial arrangements. For example, if interest rate or credit default swaps had been presented on a gross basis by financial institutions, their prudential regulators as well as investors would have been provided with a much clearer picture of the overall risk exposures of those entities. The added transparency provided by gross presentation, might have even discouraged many of the derivatives transaction that are widely believed to have been the root cause of the recent financial crisis.

The Koss Fraud: Do Smaller Companies Need New Regulations or Better Old Regulations?

The Koss Corp. fraud case has been in the news since the end of December, so why am I just getting around to writing about it now? Because, that's the way I roll, man.

I don't know if anyone has noticed that a great many of my blog posts are based on not-so-current events. My style, if you can call it that, has been to keep a low profile initially (my father would have called it "procrastinating"), and eventually attempt to provide a new slant on a more mature topic. That's why, for example, you shouldn't expect much from me on the SEC's latest IFRS missive for the next few weeks. In the meantime, you'll have these thoughts on Koss to chew on, plus a related post to come on the role of audit committees.

What Can We Learn from the Fraud at Koss?

According to Koss's SEC filings, it has only 73 employees, and 79% of the shares of this small company are owned by its directors and executive officers. I certainly don't want to minimize the losses of the passive investors in Koss (although it must be said that Koss's stock price is holding pretty steady), but methinks the legs of this case as a national story has less to do with a internal control deficiencies and/or a busted audit than with the entertainment value of a story fit for reality TV; to wit, the comeuppance of a two-bit embezzler cum pillar of the community, who also happens to be a world-class shopaholic.

The fraud at Koss was allegedly committed by the company's vice president of finance, Sujata Sachdeva, who is accused of siphoning off about $31 million of the company's cash over a five-year period. That's almost one year's worth of the company's revenues, which she allegedly spent on vast quantities of designer clothing and other high-priced tchotchkes.

Incredibly, the fraud might have continued for much longer than five years had American Express not called to the attention of Koss's CEO two large wire transfers made from its bank account to Sachdeva's personal credit card. Sachdeva allegedly did her best to conceal the wire transfers by falsifying the bank account balance.

So, at first blush, the Koss fraud appears to be little more than a sad tale of listless second-generation family management getting fleeced, along with a few passive dabblers in Koss shares. But, others apparently see it differently. For example, the headline of a CFO.com article, "Fraud Case Feeds Sarbox-Exemption Critics" from early January strongly implies that some believe that if smaller reporting companies had not been exempted from the requirement to obtain an audit of internal controls over financial reporting (ICFR), tragedies like this could be prevented.

 

The Lesson:  Fix That Which is Broken

I actually do agree that there are important lessons to be learned from the Koss case, despite its modest parameters; but that lesson is not that smaller reporting companies should have to obtain an audit of their ICFR. The lesson is more like, 'simple problems have simple solutions.' There are two sorts of reasons for this.

The first sort is related to the costs and benefits of the ICFR audit. These are discussed at length elsewhere, including previous posts of my own, so I won't bore you by repeating them here. But the second kind of reasoning is where the path to improved financial reporting lies. Not to put too sharp a point on it, but there are much more efficient options available than to simply award the audit industry a new franchise.

To see what those alternatives could be from the perspective of the Koss case, I will enumerate (in no particular order) the major overlapping systems that together serve as the barrier to financial reporting abuses. I'll demonstrate that each of them could be easily improved in ways that would significantly affect the likelihood of a fraud, like the one at Koss, from occurring.

An issuer's board of directors has a fiduciary duty to shareholders to ensure that the issuer is led by competent individuals who are motivated to achieve appropriate operational and financial objectives.

If I were a consultant to Koss, the first thing to be evaluated would be its planning and budgeting processes. Indeed, I would be surprised if Koss actually did very much beyond, say, set sales goals. But, if Koss had a profit plan, and the discipline to rigorously evaluate itself periodically against that plan, the unauthorized expenditures on clothes and tchotchkes would have become self-evident; the improper expenditures would have been too significant to ignore. 

The larger lesson is that boards of even small companies have to exercise a degree of oversight that ensures that management sets goals for itself, and that management is evaluated against those goals. 

An ICFR audit won't fix that. 

The issuer's principal executive and financial officers certify that, to the best of their knowledge and after taking the appropriate steps to become informed, the financial statements are free of material errors.

Sachdeva's official title was "vice president of finance and secretary," and Michael Koss, who has served as "president, chief operating officer and chief financial officer" for over 20 years, signed the certifications required by S-OX as both head honcho and head finance guy. Thusly, Sachdeva, who must have had free reign over the company's finances, was able to escape signing off on financial statements that she must have known were materially misstated.

This unusual statement of affairs presumably occurred with the blessing of Koss's legal counsel, who would have provided a very liberal interpretation of the applicable provisions of S-OX and SEC regulations. But, who benefited from that liberal interpretation other than Sachdeva, the only named executive officer in the executive compensation disclosures described as having a finance function? A clear lesson from this case for the SEC is that it should issue additional guidance for determining when one person at a company can sign a S-OX certification as both CEO and CFO. In my experience, the strong tendency of securities lawyers is to recommend that a company should avoid if at all possible doing more than is minimally required.disclosure regulations.

An ICFR audit isn't needed to fix that, but a more watchful securities lawyer could have come in handy.

The "independent" auditors certify the financial statements

CFO.com reported that Koss:

"… fired its accounting firm, Grant Thornton, on New Year's Eve. The auditor's response has been to highlight the fact that Koss is one of the companies that are not yet subject to Sarbox's Section 404(b), which requires an auditor sign-off of internal controls. 'The company did not engage Grant Thornton to conduct an audit or evaluation of internal controls over financial reporting,' says a spokesperson for the accounting firm. 'Establishing and maintaining effective internal control is management's and the board's responsibility.'"

Nothwithstanding anything that Grant Thornton has put out there for public consumption in their own defense, who among us has not asked themselves how GT could have missed a falsified bank balance? Few details are available, but it must be noted that the alleged fraud took place over five years, and consequently, five audits. I can't resist speculating that the bank reconciliation portions of the audit work papers were produced by the most junior person on the engagement, who failed to perceive that the large transfers to American Express (a non-vendor) for $382,000 and $1.4 million were very large red flags that something was amiss. 

And, just for good measure, I'll mention yet one more time my support for mandatory audit firm rotation.  Merely the fear of a fresh set of eyes every few years could have given the edge the auditors and needed to catch the alleged fraud before the numbers became as ridiculously high as they did.

An ICFR audit shouldn't be needed to do a bank reconciliation properly.

The issuer's audit committee, which is composed of "independent" board members and has unfettered access to its own outside experts, oversees the work of the "independent" auditors.

Three of the four members of Koss's audit committee had been serving on the board for more than two decades, and none of them list any direct experience whatsoever in accounting or auditing matters.

The audit committee financial expert was, and is still, 77-year old John Mattson. The only qualification listed for him is that he is the retired president of Oster Company, a division of Sunbeam Corporation. I don't want to cast unwarranted aspersions, but the shareholders of Sunbeam were the victims of an infamous and massive accounting fraud perpetrated by one Albert (Chainsaw Al) Dunlap in the late 1990s. I don't know whether Mr. Mattson was involved with Oster at the time, but the irony of a former Sunbeam executive at Koss while a fraud occurred is inescapable. 

An ICFR audit of Koss could have easily devolved into a mere compliance exercise with nothing to show for it is left to be overseen by an evidently disinterested, uninformed, and moribund audit committee.

The threat of enforcement of the securities laws and SEC regulations by the SEC itself and private parties discourage intentional misstatements.

Although I have nothing specifically with respect to Koss in this regard, I do want to point out a very interesting op-ed piece from Joel Seligman that recently appeared in the New York Times. Among the points he made was that the rate of financial fraud at various points in time is negatively correlated with the size of the SEC staff.

 

The SEC and analysts review issuers' financial statements

A fraud that siphoned about 20% of revenue each year could not possibly escape detection by analysts of any stripe (or the auditors for that matter) if detailed reconciliations of the beginning and ending balances of all balance sheet accounts were required in the financial statement notes. There would simply be no place to hide the fancy clothes and the overpriced tchotchkes.

An audit of internal controls does not obviate the need for appropriate external controls over financial reporting.

If the SEC is looking for demonstrable improvement in the quality of financial reporting through convergence with IFRS, they should unambiguously state to both Boards that they regard full transparency of changes to balance sheet accounts as the most effective measure for discouraging fraud and earnings management.

  

Winding Up

The point of this post is to show that strengthening elements of the financial reporting system that are already in place for all public companies would be more effective than adding a new element, such as an audit of ICFR.

We should require increased transparency through comprehensive reconciliations of balance sheet accounts, strengthen auditor independence through mandatory audit firm rotation; and strengthen board and audit committee independence through enhanced disclosure requirements and regulatory oversight. Any of these, singly or in combination, are logical next steps before considering the imposition of ICFR audits on smaller reporting companies.

Merrily We Roll Along -- Forward and Up

It took seven years for the FASB and IASB to publish its "preliminary views" exposure draft (ED) on the fundamental issues addressed by the Boards' joint financial statement presentation project. And just recently, the FASB staff has posted a ten-page tabular summary of their "tentative decisions as of December 2009."

My own views, which I have expressed in four previous points (see the list, below) are neither "preliminary" nor "tentative." Granted, I am not bound by due process constraints, but eight years and counting has been far too long to wait for closure on a project that will have absolutely nothing to say about recognition or measurement. As my previous posts will indicate, I have also been extremely frustrated by some of the puff-pastry notions contained in the DP—and that are still on the table in some form or another:

First, there is no investor value created from allowing management to determine how a transaction is classified on the financial statements. Yes, every business is different, but there are still only two principles-based categories of transactions/events in which an enterprise may engage: 'financial' and 'non-financial.'

Even rudimentary delineation of the non-financial category into 'operating' and 'investing' activities has proven futile, and should be abandoned. For example, is the acquisition of inventory an investing or operating activity? Is purchasing one new machine to replace a worn-out machine on the factory floor arrayed with 1000 machines an investing or an operating decision? At best, even the operating/investing dichotomy it is too subjective to be audited, and at bottom, it is a distinction without a substantive difference.

Even allowing that there are some informative ways to further delineate ongoing operating activities, affording management the latitude to make those determinations is a loser before the opening bell is rung. Accounting standards should require a principled separation of financing from non-financing, but that would challenge the sacred cow of interest cost capitalization—so it ain't gonna happen.

Second, no investor value can possibly be created simply by re-arranging the financial statement deck chairs, even in the name of a newly coined "cohesiveness principle." Disaggregation is where it's at, and in that regard there does happen to be a role for that idea; as I am about to explain, however, it appears to not a role envisaged by the Boards.

A Promising New Direction

Having gotten that off my chest, I do very much want this latest missive to be seen in a positive and constructive light. To wit, there is one new piece of information, to be found in the very last item of that ten-page table that knocked my socks off. It's somewhat lengthy, but worth repeating:

"Replace the proposed reconciliation … [of cash flows to comprehensive income] with an analysis of the changes in balances of all significant asset and liability line items. Each line item analysis should distinguish the following components:

a. Changes due to cash inflows and cash outflows

b. Changes resulting from noncash (accrual) transactions that are repetitive and routine in nature (for example, credit sales, wages, material purchases)

c. Changes resulting from noncash transactions or events that are nonroutine or nonrepetitive in nature (for example, acquisition or disposition of a business)

d. Changes resulting from accounting allocations (for example, depreciation)

e. Changes resulting from accounting provisions/reserves (for example, bad debts, obsolete inventory)

f. Changes resulting from remeasurements

Present information about remeasurements in the financial statements.

• FASB: require disaggregation of remeasurements on the face of the statement of comprehensive income (SCI) in a columnar format. Those two columns should be labelled total comprehensive income and remeasurements.

• IASB: require presentation of remeasurements in the notes to financial statements.

Modify the definition of a remeasurement. The working definition of remeasurement is: an amount recognised in comprehensive income that reflects the effects of a change in the carrying amount of an asset or liability to a current price or value (or to an estimate of a current price or value). A current price or value includes the following measurement attributes: fair value, fair value less costs to sell, value in use and net realisable value. [bold italics supplied; dates omitted]"

This is pretty big news, AND IT COULD BE HUGE! However, I'm afraid the devil will be in the implementation details. That's why I'm going to spell it out for the Boards in simple terms: what is actually needed, why it's needed, and how to do it.

The What — The Boards enunciated in their original exposure draft an objective that financial statements should be presented in a manner that "presents a cohesive financial picture of an entity's activities." I'm not exactly sure what they mean by "cohesive" even after looking up that term in a few dictionaries.  Nonetheless, as a metaphor to financial reporting, the term resonates as regards the relationship between financial statement notes and the financial statements themselves. "Cohesiveness" should mean that the financial statements hold together, in a coherent or cohesive manner, the quantitative information in the notes. Stated even more plainly, every balance sheet line item should be "rolled forward", and each line item in the 'flow financial statements' (e.g., income statement, statement of cash flows, statement of changes in shareholders' equity) can be found to be the sum of line items in those balance sheet item roll forwards. That's what I mean by HUGE.

The Why — As I have already stated, disaggregation is where it's at. With XBRL around the corner, analysts will most certainly be competing with each other to create the sexiest non-GAAP measures of financial performance they can by plucking a little tagged something from here, and combining it with a little tagged something from there. If you're a sports fan, you are probably aware of all the new and interesting baseball stats created by imaginative analysts—once they were able to get their hands on the underlying data.

The statistics revolution in financial reporting should make the baseball stats revolution look like—well, what it is—a mere game. To pick just two of hundreds of possibilities an analyst should be able to identify each component of a foreign currency translation adjustment, and decide whether to accept it as presented, or to make one's own pro forma adjustments. Or, if you don't like capitalized interest, an analyst should be able to reverse every stinking dollar of it.

A more subtle, but equally important reason for comprehensive roll forwards is that it will be a huge enhancement to external controls over financial reporting (and along with that, something for an auditor to really audit). Much has been said and written about the importance of internal controls over financial reporting, but a financial regulator's basic responsibility is not merely to mandate internal controls, but to impose substantive external controls. Any control expert should tell you that if you can't roll forward a balance sheet account, you can't hardly test its accuracy. If everyone should be doing their roll forwards internally, and they are quite obviously an efficient form of disclosure, then what is keeping regulators from mandating them? (The sad answer to this question shall be provided anon.)

The How — The extract I have provided from that ten-page table leaves a lot of implementation questions unanswered; and admittedly, it's only a summary of what the Boards may be thinking. The area of greatest concern to the Boards appears to be the level of detail to be provided in the roll forwards.

Once again, that new-fangled "cohesiveness principle" makes the answer to their dilemma straightforward: the Boards need merely to specify that the line-item detail of the roll forwards must be sufficient to allow "roll ups" to each of the lines in the flow statements. For example, if the FASB wants to separately identify "remeasurements" (more on that unfortunate term later) on the statement of comprehensive income, then the remeasurement components in a balance sheet line item roll forward must perforce be set forth.

I am compelled to add as an aside, though, that if the board is struggling to define "remeasurement," they should first acknowledge that the term is already spoken for in another part of GAAP. ASC 830-10-45-1 (within the Foreign Currency Matters topic) identifies remeasurement as a process by which the books of record of an entity are converted to its "functional currency." Contrary to the Boards' proposed new definition, what is currently regarded as remeasurement does not necessarily result in "current prices" or "current values." So, if new terminology is indeed required, which I recognize is likely the case, I would humbly suggest a couple of terms that convey the objective more straightforwardly: like "revaluaton" or "valuation adjustment."

Alas, the "Why Not"

The sad reality is that issuers will balk severely and senselessly at comprehensive roll forwards. And, who knows whether the toes-in-water approach now suggested by the Boards will prevail, or perhaps ultimately drive a wedge between them? I'm betting that the FASB will insist on something at least close to the sensible approach that they have finally put forward.  Meanwhile, the EU will threaten to ditch the IASB unless they get back with the a la carte chicken-salad-for-issuers program they have ordered.

As for yours truly, I don't believe issuers who will claim that balance sheet roll forwards (much less a direct cash flow statement) are a bridge too far – and neither should any reasonably intelligent undergraduate accounting major. If consolidated income statements already articulate to consolidated balance sheets, then why can't the components of those statements articulate? The simple answer is that they should – and they must.

Simple can be beautiful; that's why I like accounting. Comprehensive roll forwards that permit comprehensive roll ups would not solve every single problem that exists in regard to financial statement presentation.  But, by comparison to every other concept or objective offered up by the Boards during the past eight years and counting of this project, everything else is weak tea.
-------------------------------------------------

*Those four posts are as follows:

The "Preliminary Views" on Financial Statement Presentation: Seven Years of Deliberation for This?

Financial Statement Presentation: The Sequel

Making Financial Statement Presentation Simple: Mandate Account Reconciliations

Financial Statement Presentation: Will Issuers or Investors Prevail?

A Modest List of Financial Analysis 'Red Flags'

My blog 'readership' (shame on me for using such a stuffy term!) primarily consists of preparers, auditors and journalists. But, for those intrepid analysts who actually do read my blog, this week I have something especially for you! I humbly offer you a list of red flags to think about adding to your own personal collection.

But first, permit me this minor rant.

I have given some thought as to why analysts may be somewhat indifferent to my commentary – or more importantly, why very few submit comments of their own on SEC/FASB rulemaking proposals. My gut feeling is that analysts tend not to create much value for themselves by taking time to think about what financial reporting should be. To do so would just take time away from one's core activity of decoding the steady stream of dressed-up offal, prepared according to the latest financial reporting recipe book and tastily seasoned by management.

My objective in pointing this out is to make the point that it is a grave mistake for policy makers to believe that analysts are interested in accounting rules that make the world a better place. Just like most everyone else, financial analysts are focused like laser beams on creating value for themselves. The policy implication is that, instead of pining for more comment letters from investors, the FASB and SEC (and IASB) should acknowledge the free rider problem in their 'due process' deliberations. To my way of thinking, investor protection is usually accomplished by the exercise of common sense a la Justice Louis Brandeis' sunlight being the best disinfectant rule of thumb, and policymakers should have the gumption to act accordingly. Comment letters from special interests urging some other path are dross, even if they outnumber investor comments by a margin of 100 to 1.  

Now, on to the red flags.

#5 – Younger companies meeting growth projections for the umpteenth time in a row. I am suspicious when a relatively young company has consistently generated above average returns even while its product portfolio is clearly maturing, and its industry has become more competitive. It is often the case that management seeks to extend its recent record of rapid growth in sales and profitability by unconventional means, because it has not been able to identify investment opportunities within its historical core competency (generally, some form of cost reduction or product differentiation strategy). That's when the earnings games begin: aggressive estimates, drawing down 'earnings banks', selling assets for accounting gains, taking on excess leverage, or entering into byzantine financial transactions.

The Apollo Group, which I wrote about regarding the SEC's investigation into its revenue recognition policies, seems to fit the profile. It entered the for-profit college degree business when it was still young, and appears to have established the model for later entrants to emulate. Moreover, one of its more distinctive products, online classes, seems to be becoming commoditized as non-for-profits have undertaken changes in their "business models" to better respond to the needs of part-time and geographically distant students.

#4 – Management has adopted a minimalist approach to disclosure. My suspicions, and my hackles, are raised by multibillion dollar companies claiming that they have only one reportable segment. Some might say that that management, by evading segment disclosure, is fighting the good fight so as to prevent actionable information from falling into the hands of competitors. But, something is rotten in Denmark when companies alter their internal communications for the apparent purpose of floating a disingenuous tale that their "chief operating decision maker" is willingly in the dark when it comes to significant components of its operations.

When ITT Educational Services Inc. reports having an executive officer of its "online division," yet implicitly claims that it has no obligation to provide disaggregated information on that part of their business (either in MD&A, or the financial statement notes), I become suspicious. Although Apollo does provide some segment disclosures, its annual report is notably silent on the effects of online courses on recent earnings trends. (Some unsolicited advice to both companies: I respectfully suggest that they read the SEC's enforcement release regarding Sony's MD&A deficiencies and take heed. All it could take is one impairment charge or restructuring to put the Enforcement Division on their tails for similar omissions.)

I also blanch at boilerplate MD&As, particularly when no overview section is provided, the summaries of critical accounting policies are rote recitations of standard GAAP, and mechanical recitations of numbers masquerade as "analysis."

Here's a portion of Apollo's MD&A that caught my attention, and which I did not to mention in my earlier post. To set the stage, you should know that Apollo reported gross student accounts receivable of $380 million less an allowance for doubtful accounts of $110 million. Total revenues reported were $3,974 million.

"For the purpose of sensitivity, a one percent change in our allowance for doubtful accounts as a percentage of gross student receivables as of August 31, 2009 would have resulted in a pre-tax change in income of $3.8 million. Additionally, if our bad debt expense were to change by one percent of total net revenue for the fiscal year ended August 31, 2009, we would have recorded a pre-tax change in income of approximately $39.7 million."

Even ignoring the wow factor of Apollo's gigunda allowance for doubtful accounts, SEC rules imply that a sensitivity analysis should flex base estimates by a minimum of 10% (see Regulation S-K, Item 305, on sensitivity analysis for "market risk sensitive instruments) to be reasonably indicative of the underlying risks being modeled; Apollo's is only 3.5% (= 3.8/110); by comparison, a grudging token.

On the other hand, Apollo does report that if their allowance were an additional 1% of revenues, net income would be reduced by a much more significant sum. However, that statistic hardly qualifies as a "sensitivity analysis." That's because cash flows underlying revenues can come from either tuition payments made in advance (a very substantial amount in Apollo's case), or from payments made in arrears. Multiplying a non-collection rate, however determined, by cash flows that have already been collected makes no sense.

Finally, another pet peeve of mine is when there are no substantial differences between this year's and last year's MD&A, except for different numbers inserted between the words.

#3 – Management is obsessed with earnings reports. Beware of companies whose management appears to be fixated on reported earnings, usually to the detriment of attending to real drivers of value. Indicators include the aggressive use of "non-GAAP measures of performance," "special items" or "non-recurring charges." Watch out as well for highly decentralized operations where division managers' compensation packages are heavily weighted toward the attainment of reported earnings or those non-GAAP measures of performance.

Here are two examples of apparently obsessed managers. The older example is one that I have written about in the past. GE, under Jack Welch's leadership, had acquired Kidder-Peabody in the mid-1980s.  It was ultimately determined that much of the earnings that Kidder had reported were bogus.  As a consequence, GE was would announce within two days that it would take a non-cash write-off of $350 million.  Here is how Jack, "there was only one way – the straight way," Welch described the ensuing meeting with senior management in his memoir, Straight from the Gut:

"The response of our business leaders to the crisis was typical of the GE culture [my emphasis].  Even though the books had closed on the quarter, many immediately offered to pitch in to cover the Kidder gap.  Some said they could find an extra $10 million, $20 million, and even $30 million from their businesses to offset the surprise.  Though it was too late, their willingness to help was a dramatic contrast to the excuses I had been hearing from the Kidder people." [p. 225]

I doubt if, in this post-Enron and S-OX 404 environment, a CEO today would so openly express such a blatant disregard for reporting to investors, but I also doubt if things have changed much at many companies – especially those where the CEO and board chair are one and the same, stock options to the CEO have the potential to dwarf the other compensation components, and the audit committee lacks gumption and sophistication.

A more current example is Overstock.com, which Floyd Norris very colorfully described in his NYT blog. In brief, their CEO fired the company's newly-appointed auditor before it could even render its first opinion on the company's annual financial statements. The auditor's crime, it appears, was to have changed course on the treatment of a non-recurring gain: whether it should be reported as income in the current year, or should have been pushed back to a prior year. In other words, no cash flow effect, and no discernable consequences on future operations. I would not be surprised if the accounting treatment directly affected the CEO's 2009 cash bonus, or tips the company toward the wrong side of a loan covenant.

#3 – Restructuring and/or impairment charges. Years ago, it was often the case that a company's stock price would rise after it recognized a "big bath" charge to the current period's earnings. The conventional wisdom was that accounting recognition signaled either that management was now ready to part with the lagging portion of a company, so as to re-direct its attention and talents to the potential 'stars'; and/or the earnings charge itself should be ignored, because it related to past events of no relevance to an assessment of the company's future earnings potential.

My take, however, is that the events leading ultimately to the big bath on the financial statements didn't happen overnight, even though the accounting for those events sure makes it look like the world was destroyed in one fell swoop. Management may want you to believe that the balance sheet cleanup will put the company back on the old path, but the problem is that the old path of reported earnings wasn't itself real. Restructuring charges and impairments mean that expenses of prior years' earnings were very likely overstated relative to economic earnings, even if all was strictly according to the letter of GAAP. When I had students, I counseled that if one cared to extrapolate historic earnings trends, one should make a pro forma haircut of prior years' earnings for a reasonable share of the current period's restructuring and impairment charges.

#2 – Management has the M & A bug. Business combinations accounting has forever been a fertile ground for earnings management. Take Tyco. According to SEC documents, from 1996 to 2002 it acquired more than 700 companies. First, beware of a growth-at-any-cost corporate culture and the likely ineffectiveness of both operational and financial reporting controls to efficiently absorb all of those changes. Second, the SEC claimed that Tyco used just about every business combinations accounting trick in the book to juice earnings. Granted, the rules of the game have been changed somewhat by FAS 141R, the newest business combinations standard, but opportunities to juice earnings and to create 'earnings banks' still abound by understating assets acquired and overstating liabilities assumed.

#1 – An SEC investigation.  The SEC's investigation of Apollo may only have as its initial focus one particular area of revenue recognition. But, where there is smoke, there could be a forest fire. The SEC may find grounds to challenge Apollo's entire revenue recognition policy. Or, with their subpoena powers wielded broadly, the SEC could stumble onto other questionable areas as well. Is Apollo willfully hiding lackluster performance of, say, its online programs a la Sony; or is it juicing consolidated earnings with questionable accounting for recent acquisitions? Who knows?

For that matter, will Apollo's public company competitors (like ITT) get caught up in the SEC's web? Who knows?

A Final Caveat

Numerous commentators and researchers before me have discovered some pretty powerful systems for extracting negative indications of financial health from accounting data. I am in no way trying to replicate that work, nor am I suggesting that the red flags I have proffered are the product of a similarly rigorous and systematic approach, or the state of the art. My goal has been only for each reader to think just once, "I hadn't thought of that one; it could make sense."

  

Financial Statement Presentation: Will Issuers or Investors Prevail?

The comment period has ended on the IASB and FASB's joint discussion paper (DP), Preliminary Views on Financial Statement Presentation, and it looks like there's going to be a rumble between investor advocates and issuer special interests. I have written three posts in the last few months on this topic (one, two, three), and I am drawing on two additional sources for this post: the CFA Institute's comment letter, and Tim Reason's CFO.com piece headlined "Critics Pan New Financial Statements."

The Statement of Cash Flows: Direct v. Indirect Method

The most basic of all proposals in the DP was to fix the loophole in SFAS 95 allowing the indirect method and mandating the direct method for the statement of cash flows. Among those who issuers claim to serve, however, it's a must have; according to the CFA Institute:

"We strongly support the adoption of the direct method cash flow statement as it would be a significant step towards improving financial reporting. The DM [direct method] offers insights into the quality of revenues, earnings and the characteristics of the cash conversion cycle, which are not available from an indirect method of reporting cash flows from operating activities. The DM is also consistent with and achieves greater relevance of disclosure of gross rather than net amounts. We strongly believe that the benefits outweigh the cost of adopting this method. In addition, we believe that the information provided by DM cash flows would be beneficial to management as well as investors. [Bolding in original]

But, according to CFO.com, issuers appear to sing a different tune in their comment letters. Here's CFO.com quoting from IBM's comment letter:

"IBM 'is aware that limited academic research supports the hypothesis that the direct method of cash flow provides better predictive value to future operating cash flows than either the indirect method or the income statement,' wrote Gregg L. Nelson, the company's vice president of accounting policy in financial reporting. But if that were true, he argued, companies themselves would use that information for internal reporting, something IBM and many other companies insist they do not do. 'To state the obvious,' added Nelson, 'future cash flow is largely driven by future transactions. Historical data is of limited predictive value.' IBM, he wrote, believes that revenue, days sales outstanding, changes in accrual balances and company information should be sufficient for investors to make their decisions." [Italics supplied.]

I love that part about 'if the direct method were useful, we'd be using it.'  It makes me feel like Voltaire's Candide, smugly assured by Pangloss, the pseudo-intellectual, that all is for the best; if there had been a better way, management would be all over it.

Right.  Are you really saying, Mr. Nelson, that IBM doesn't actually care to know where its precious cash came from, and where it went? How about cash planning?  If Nelson is actually saying that IBM management cannot answer those questions for itself, then I say "SELL!" Just to ratchet things up a little, ask yourself how credible Nelson's statements would be if they emanated from the ruby lips of his counterparts at GM, Ford, Chrysler or some other company flirting with bankruptcy. 

Implementation costs of switching to the direct method are also a factor noted by issuers. CFO.com cites Intel's letter, which claims that it will cost them $5 million in the first year to convert their accounting systems over to the direct method, plus $2 million every year thereafter. I'm not a software guru, but I have trouble taking such dire warnings at their face value. It can't be too hard to pull out each cash receipt and disbursement, sort them into about fifty different buckets, and add up the totals in each bucket; probably 99.9% of that be done automatically. 

On the other side of the cost equation, I'm guessing that the thousands of investors who actually want to understand Intel's financial statements spend a lot more than $5 million worth of time each year attempting to reverse engineer Intel's indirect method statements, along with trying to make heads or tails of the gobbledygook, boilerplate explanations of liquidity trends in their MD&A (I haven't actually read Intel's). For those of you accounting educators who I am fortunate to have as a reader, you will especially appreciate the millions of hours we spend trying to get students to think while they are standing on their head, as it were, in order to get their brains around preparing a cash flow statement; or just being able to read and understand the indirect format.

The Reconciliation of Cash Flows to the Comprehensive Income

The CFA Institute's comment:

"The requirement to present the schedule in the notes to financial statements that reconciles cash flows to comprehensive income and disaggregates comprehensive income into four components: (a) cash received or paid other than in transactions with owners, (b) accruals other then read measurements, (c) remeasurements that are recurring fair value changes or valuation adjustments, and (d) remeasurements that are not recurring fair value changes or valuation adjustments. We would not get information on operating changes versus investing decisions versus foreign exchange rate effects – currently provided (albeit poorly and/or incompletely) in the indirect cash flow statement reconciliation. We recommend and strongly prefer the statement of financial position reconciliation as it provides more comprehensive information and includes the statement of financial position and direct cash flow statement."

Just like one of my earlier posts, the CFA Institutes wants a line-by-line reconciliation of each balance sheet category. That's essentially what I have been pushing for (see this post), but the CFA is asking for comparative balance sheets in full reconciliation format. I imagine that the CFA Institute is working on the entirely valid assumption that disclosures are not taken as seriously by auditors and issuers as amounts on the financial statements. That's a great point, but I'm concerned that important information can become overly aggregated. For that reason, I had envisioned highly detailed reconciliations presented as tabular disclosures -- like what the IASB requires for some, but not all, accounts.  It's critical that it be required for all accounts.

CFO.com did not report that issuers squawked much about the cash flow reconciliation. Execs, no doubt, are aware that the Boards considered balance sheet reconciliations in their deliberations, but ultimately got enough pushback to contract a case of cold feet. So, issuers probably want to let sleeping dogs lie at this juncture. That's one reason why I would be willing to, albeit reluctantly at this point, settle for note disclosure, as a sort of compromise.

Classification According to Operations, Investing and Financing

CFA Institute supports the Boards' preliminary views to carry the same classification scheme (i.e., operations, investing and financing) across the three main financial statements, but issuers are objecting. Banks, in particular, are not sure how to reasonably go about separating their operating activities from their investing activities. There may also be a difference in preferences between the IASB and the FASB here; the former might be more comfortable with classification decisions made by management subject to some general 'principles' (a view I absolutely abhor), but U.S. issuers may prefer more FASB-like rules to back them up.

I am actually in the issuer camp on this one. I don't think it is possible to make a principled distinction between operations and investing for any industry. Try these:  Is the acquisition of inventory investing or operations? Is purchasing new equipment to replace old equipment an investing or an operating decision? Are planned expenditures on a 20-year-old oil field to extend proved reserves a part of normal operations, or are those expenditures an investment?

However, as I have stated here, I am very much for a principled distinction between financing transactions and everything else. I see no useful purpose in allowing management the discretion to fiddle with what goes where; but, it should be a straightforward exercise to write rules for classifying financing transactions apart from everything else.

Overall, though, I think organizations like the CFA Institute treat the FASB much too gently. They should be telling them also that, even though there are some satisfactory portions of the DP on financial statement presentation, it doesn't come close to going far enough. They should be telling them that convergence is not near as important as getting it right for U.S. investors. They should be SCREAMING that irrespective of the rules we have for recognition and measurement or the reporting of other comprehensive income,  financial reporting will never be what should be without a full balance sheet reconciliation and a direct method statement of cash flows.