Ethics and accounting

The recent happenings in the business world have focused accountants on the importance of ethics. Recently the following information was released:

National Association of State Boards of Accountancy (NASBA) recently published an exposure draft that seeks to revise Rules 5-1 and 5-2 of the Uniform Accountancy Rules. These rules specify educational requirements to become a CPA.

NASBA indicates that the the proposed revisions reflect greater detail on accreditation and the appropriate scrutiny accompanying each level of accreditation. In addition, the revisions include increases in the number of semester hours required in accounting (from 24 to 30) and business (30 to 36) as well as specific hourly requirements for both accounting and business subjects, including three hours of ethics in accounting and three hours of ethics in business. The proposal also includes specific requirements for general business education outside of the accounting area, as well as integration of communication and research across the accounting curriculum.

The entire proposal has a number of interesting points, but they all result in more accounting courses, and more ethics.

(Almost) final tally on lease restatements

Bloomberg reports today that 51 companies have restated their earnings due to problems with lease accounting and the restatements have resulted in reducing pre-tax earnings by $1.5 B.

From the story:

McDonald's Corp., Borders Group Inc. and 50 other companies have lopped more than $1.5 billion off their reported pretax earnings since federal regulators urged them in November to review how they account for leases of stores and other rental properties, company filings show.

The U.S. Securities and Exchange Commission is disputing the accounts of restaurant chains, retailers and others, saying they may have ``deviated from standard accounting practices'' by not recording rents and writedowns for store improvements evenly over the years of leases. Not following the rules can increase quarterly profit.

Lease accounting can lead to a number of problems and an examination of these issues can bring forth a lot of classroom discussion. One question that students should think about is why most of these restatements have gone in the direction of reducing pre-tax earnings? Is this the result of honest mistakes or are managers using the details of lease accounting to manage earnings?

What does this say about the accounting profession - are accountants being proactive in uncovering mistakes or are they, as Lynn turner suggests:

The required accounting treatment doesn't affect how much money companies pay landlords. Rather, the rule obliges companies to deduct lease costs more evenly, leading to the spate of earnings restatements.

The required accounting treatment doesn't affect how much money companies pay landlords. Rather, the rule obliges companies to deduct lease costs more evenly, leading to the spate of earnings restatements.

The required accounting treatment doesn't affect how much money companies pay landlords. Rather, the rule obliges companies to deduct lease costs more evenly, leading to the spate of earnings restatements.

``This really demonstrates that accountants are falling into the same old rut they were in before Enron,'' said Lynn Turner, a former SEC chief accountant who now is managing director of research at Glass, Lewis & Co., a corporate governance advisory firm in Denver.

Deferred Taxes

There have been a number of companies that either have had to restate earnings as a result of deferred tax problems or stated that accounting controls can not be relied on due to problems with deferred tax accounting. Today Tasty Baking stated that the reason it done the following to improve its internal controls over deferred taxes:

To improve control of the way it accounts for income taxes, the company said it has implemented additional monitoring controls and has documented the methodology and tools for calculating and reporting tax-related transactions.

In addition, Con Agra stated that it would restate earnings due to income tax errors:


ConAgra Foods Inc. said it would restate its financial results for 2004 and the first half of fiscal 2005 because of income tax errors that could cost one of the nation’s largest food companies up to $200 million.

I wonder if this is the start of the next wave of restatements.

Operating Cash Flow

In an earlier post I discussed the SEC's decision to force companies to change how they classify certian cash flow activites. Today's WSJ has an article detailing how that change is starting to affect certain companies:

Major companies like Caterpillar Inc., General Motors Corp. and Ford Motor Co. have recently slashed their previously reported numbers for operating cash flow in response to the Securities and Exchange Commission's stance that they have been incorrectly categorizing their vendor financing for cash-flow purposes. While expected, now that annual reports are rolling off the presses, it is becoming clearer how much some companies are affected.

The change really affected Caterpillar who saw its cash flows from operations decrease by over $14 Billion dollars in 2002-2003. Recall that this change results from how companies treat receivables that are creatted when the company provides loans or other financial assistance to its dealers to help them buy products out of the company's inventory. In the past companies treated these receivables as financing activities, but now the SEC requires that companies treat these receivables as operating activities.


Here is Caterpillar's recent Cash Flow Statement with the relevant accounts in bold:





Its important to note that Caterpillar gets hit harder than most companies because as the article states:

Caterpillar's operating cash flow is suffering harshly in part because its finance receivables go into an off-balance-sheet entity, and Caterpillar receives "retained interests" in the receivables, not cash, in exchange for a portion of them. In its annual report, Caterpillar said accounting rules dictate that its collections on those retained interests must be treated as an investing transaction, rather than an operating transaction, and that results in a "significant" shift in cash flow away from operating and to investing.

Demand for CPAs

An article in today's Wall Street Journal discusses the huge increase in demand for CPAs. the managing director at PWC states that hiring at all levels is up 30%. In another part of the article it states that the salary for a junior level partner is $500,000 on average, specialists in forensic accounting can make even more.

The human resource director at BDO Siedman states that they would hire everyone available with experience in SOX work.

The article also provides some stats about tne number or accounting graduates. In 1991 60,000 accounting degrees were awarded, by 1999 that number had decreased to 45,000 and in 2002 the number had jumped back up to 50,000.

Here is the big takeaway:

In the past, the ideal public-accounting candidate was a recent college graduate who could be trained by an employer. Now, companies are seeking out experienced people who have more diverse skills.

"They need to be able to build relationships with audit clients...and have the ability to train and mentor the staff underneath them," says Ms. Brannon. "We are looking for true business advisers, not just number-crunchers."

Deferred taxes

There was an interesting paragraph in Rogers Corporations fourth quarter earnings release:

In connection with the Company’s year-end financial statement closing process and the audit of the consolidated financial statements by the Company’s independent public accountant, it was determined that the method of accounting for deferred income taxes was not consistent with the application of the provisions of FAS 109. The one-time, non-cash increase to earnings reflects the adjustment required to properly state certain deferred income tax accounts for temporary tax differences that may have accumulated over many years. Management believes that any temporary differences not properly accounted for would not have materially affected the Company’s reported results in any one year nor was the cumulative amount material in relation to the Company’s financial position. As such, with the concurrence of the Company’s independent auditors, the adjustment for these items was recorded in the fourth quarter 2004 results.

This seems like a strange omission, the company was not able to verify that its internal controls were able to allow it to calculate its deffered taxes and that it would result in an increase in earnings. Why would the company have lowered its earnings in the past through deferred taxes? However, it is interesting that the company was not able to maintain controls over its deferred taxes, will this be the next wave of restatements?

AIG and Leasing

The information that is coming out about AIG and finite risk insurance is fascinating. It also raises the question of whether the current leasing standard needs a complete overhaul. Based on a NY Times article it appears that AIG used finite risk insurance to get favorable lease accounting treatment. Here is the relevant portion of the article:

International Lease bought a residual value insurance policy - a policy that was meant to cap liability in its leases - from General Re, according to a former senior executive of A.I.G. General Re is the reinsurance unit of Berkshire Hathaway, the holding company run by the billionaire Warren E. Buffett.

International Lease, based in Los Angeles, undertook the transaction to reduce, by at least hundreds of millions of dollars, the amount of debt it had taken on to finance a certain number of aircraft, according to the former executive.

But the transaction also contained a provision in which International Lease effectively guaranteed that General Re would not suffer any losses from any waning residual values, or what the aircraft would be worth when their leases expired.

Not only was International Lease able to reduce its reported liability on the aircraft, but the transaction enabled the company to treat the leases on the planes as finance leases. The transaction allowed a more favorable accounting treatment for the leases that enabled the International Lease to recognize income from the leases more quickly than before.

So it appears that Lease Finance Corp. purchased airplanes on credit and then leased the aircrafts to others. However, in order to get favorable capital lease accounting, it had to structure the deals with higher than normal residual values in order to get above the 90% test.
Lease Finance Corp. did not get the lessee's to guarantee the residual values because then they would not be able to get operating lease treatment (keep the airplane and any related debt off of their balance sheets).

So, Lease Finance Corp. went to General Re and had them guarantee the residual values. It appears that they did this by paying an upfront "insurance claim" on residual value losses to Lease Finance Corp. which turned around and used the claim to pay off some of its debt.

Debt payments were turned into "insurance premiums".


Here is how I think the journal entries would go:

Lease Finance Corp:

airplane debit
debt obligation credit

Lease receivable debit
airplane` credit
Unearned income credit

Cash (insurance claim) debit
???Leasepayment rec. credit

debt obligation debit
Cash (insurance claim) credit

Merger Fees

There is an interesting article in Accounting Web concerning the FASB proposal to expense fees paid to investment bankers and others when completing mergers and acquisitions. This is an interesting issue in the capitalization versus expensing debate. The fees tend to run about 1 - 2% of the total deal and in many large M&A transactions can get be close to $100M dollars. The question seems to be are these costs part of the acquisition or are they an expense of the current period?

Companies now account for these professional fees as part of “goodwill,” or an intangible asset on the balance sheet, as if the fees were part of the acquired company's assets and liabilities.

On the other hand aren't these fees analagous to shipping and handling fees for equipment? Companies have to incur professional fees in order to complete the M&A, so why should the fees be expensed this period? In addition, the M&A will (hopefully) provide benefits to future periods and even though the goodwill that the fees wil become part of will no longer be amortized shouldn't the fees be part of an asset?

Accounting is the #1 College Major

The AICPA just published its annual review of the supply and demand for accounting graduates and the future looks bright! Accounting majors and graduates are both up, enrollments are up 17%, bundergraduate degrees are up 6% and MACs are up 30%. On the demand side, firms increased hiring at the undergrad level 5% and at the MAC level 8%. The AICPA's report also reports that Accounting is again the #1 major on college campuses.

Back to Postings

Sorry for the decrease in postings, we had our third child on Tuesday and I have been out of the loop for the last couple of days. There has been a buildup in material, so expect increased posting this week!

Banks' loan loss reserve

Business Week has a great article about how banks have increased earnings in 2004 by decreasing their reserves for loan losses. The loan loss researve should reflect economic conditions and the economy has become stronger over the last year and a half. However, BW suggests that the decreases in loan loss reserves are a bit more than ordinary, additionally when the economy does lose steam the loan loss researves will need to be boosted again and that will only hurt future earnings. The Business Week article discusses the case of Comerica that decreased its loan loss reserve and was able to increase quarterly earnings by $98M. Looking at the 10-Q we find the following:

		September 30,				December 31,				September 30,
(in millions, except share data)		2004				2003				2003
		(unaudited)								(unaudited)
ASSETS
Cash and due from banks		$	1,560			$	1,527			$	1,955
Short-term investments			5,055				4,013				4,805
Investment securities available-for-sale			4,198				4,489				5,086
Commercial loans			21,146				21,579				22,030
Real estate construction loans			3,276				3,397				3,496
Commercial mortgage loans			7,931				7,878				7,631
Residential mortgage loans			1,263				1,228				1,210
Consumer loans			2,722				2,610				2,501
Lease financing			1,260				1,301				1,289
International loans			2,117				2,309				2,478
Total loans			39,715				40,302				40,635
Less allowance for loan losses			(729	)			(803	)			(802	)
Net loans			38,986				39,499				39,833
Premises and equipment			399				374				368
Customers’ liability on acceptances outstanding			41				27				22
Accrued income and other assets			2,720				2,663				2,726
Total assets		$	52,959			$	52,592			$	54,795

Looking at the reserve rate it goes from 1.974% in 2003 to 1.836% in 2004. If Comerica had used the same reserve rate in 2004 that it had used in 2003 the allowancee would have been $784M instead of $729.

In addition, here is an interesting quote from the article:

Tinkering with loan-loss reserves also distorts the true quality of bank earnings. A dollar of earnings in a quarter when the provisions are being reduced isn't as valuable as one when they're the same or rising. "Everybody can play the loan-loss game to varying degrees, and the market is generally going to see through it," says Craig Woker, a bank analyst at Morningstar Inc.

But that's not so easy for those investors who aren't well-versed in the nitty-gritty of bank bookkeeping. Bove thinks that bank reserve accounting needs a major overhaul. "In reality, it is really nothing more than a bunch of accountants flipping coins and playing games," he says. For now, investors should realize that the gravy train of 2004 may soon grind to a halt.

Thequote touches on earnings management, ethics, earnings quality and how many in business currently view the accounting profession.