First Edition 

SEC to provide guidance on error correction.

Interesting article in the WSJ today about whether companies should be required to fix errors of previous financial statements. There is no real controversy that material errors should be fixed, the question is whether the error is material today. What do we mean here, well specifically the issue relates to self-correcting errors. Think about inventory, errors in inventory are self-correcting so a $50 error in 2002 causes a $50 error in the opposite direction in 2003, so if the error was discovered in 2004 it would be considered $0 under the "Roll-over Method", however under the "iron curtain approach" we have a $50 error in 2002 and a $50 error in 2003, and if $50 is material both years would need to be corrected. Most companies use the roll over method to analyze errors, which results in fewer error corrections, the SEC should provide guidance this summer.

How to record a gain by adopting FAS 123 (R)

Two of the interesting items in Amazon's first quarter press release were that, one, it adopted FAS 123 (R) starting with the first quarter, and two, the adoption resulted in a cumulative effect gain of $26 million dollars. So how does adoption of FAS 123 (R) result in a gain? Well the specifics of Amazon's gain are not available but here is what might have happened. Most option plans start out as fixed plans, so that compensation expense is measured only once on the grant date. Amazon probably had a fixed plan and issued options at the market price, given that it was using the intrinsic method for calaculating compensation expense, the company recorded no comp[ensation expense.

However, Amazon after the market decline probably repriced its option which resulted in the fixed plan becoming a variable plan, now remember that this would result in compensation expense being measured at the end of each period (think of stock appreciation rights plans).

So imagine that in 2000 Amazon issued an option with a seven year vesting period when the market price was $50 to purchase a share at $50. Intrinsic value = $0, no expense.

2003 comes around the stock price is down to $10, amazon reprices the options to $10. The fixed plan becomes a variable plan and at the end of 2002 the market price of Amazon stock is $30, so intrinsic method total compensation expense would be $30 - $10 = $20 and this would have to be allocated over the remaining service period of 4 years. So, 2003 would get $5 of compensation expense.

However, assume that by the end of 2004 Amazon's stock price is now back down to$15, under the intrinsic method total compensation expense would be $15 - $10 = $5 and cumulative compensation expense to date would be $2.50 (2 years remaining on the vesting period from the repricing date), However, amazon has already recognized $5 last year, so the company would have recognized too much compensation expense to date and would get a cumulative effect type gain.

This is a great example for explaining the intricacies of variable vs. fixed option accounting and illustrates the major deficiency in FAS 123 (R) which is that compensation expense for fixed plans is only measured at the grant and is never updated.

Stock options and accelerated vesting

It appears that one method a number of companies are using to beat the impact of stock option expensing is "accelerated vesting" . This stock option expense is normally associated with options granted below market value, when even under the intrinsic method of accounting for stock options you end up with a large "stock compensation expense". For example, Google issued stock options to employees during its pre-IPO days that had an intrinsic value of approximately $750 M. (i.e. the exercise price of the options were$750 M less than the market value on the grant date).

Companies with this type of stock option expense have increasingly been using the accelerated vesting method associated with FAS 123 and Financial Interpretation 28. For Google, this resulted in expensing $623M of the $750 M in three years, as opposed to straight lining the $750 M over the vesting period.

Why would Google or other companies use accelerated vesting? Well if SFAS 123 (R) was going to be implemented starting this quarter (as most people would have thought) then Google would have already amortized the majority of this portion of stock compensation expense and would have been able to go forward with only the fair value of its other stock plans.

This is what is confusing, Google in its footnotes does not give the fair values of each separate component of stock compensation, it only (in footnote 1) provides the "Total stock-based compensation expense under the fair value based method for all awards, net of related tax effects) (page 78 of annual report).

This amount matches up closely with the "stock based compensation expense included in reported net income, net of related tax effects".

However, these two amounts cover different groups of options, so we really have no idea what the fair value of stock compenastion is for option granted when the exercise price equals the fair value.

The footnotes for Google are pretty complicated, and would be great to use in an advanced discussion of stock based compensation.

Coke is it

The SEC concluded that COKE pressured some of its bottlers to buy extra concentrate during the period of 1997 to 1999. It has been a long time (probably since the Chainsaw Al days at Sunbeam) that I have heard of a case of "channel Stuffing" to inflate profits. An excellent book about these types of frauds (and oh to be clear "Coke niether admitted or denied the SEC charges") is The Financial Numbers Game by Charles Mulford and Gene Comiskey, which examines all types of scams.

Here is some information from the WSJ article on the transactions:

During the period in question, growing competition and economic volatility around the world was making it increasingly tough for Coke to meet earnings targets. Coke offered the bottlers favorable credit terms, and their inventory levels surged 62% during the three-year period, compared with an 11% increase in drink sales, according to the SEC. Concentrate is the syrupy base ingredient used to make soft drinks.

The scheme enabled Coke to meet Wall Street profit targets in eight of the 12 quarters, the SEC said. While the sales technically were legitimate, Coke failed to disclose their existence or financial impact, concealing its full sales and profit condition. "This is a disclosure issue," said Katherine Addleman, associate director of enforcement for SEC's district office in Atlanta. "We are not alleging Coke falsified the numbers."

Hey wasn't Warren Buffett a director of Coke back then?

Yes, yes he was.

Stock Options delayed

Well the SEC did vote to delay the implementation date of SFAS 123(R), I guess we will start seeing a lot of press releases like this:

RehabCare Group Inc. (RHB) said Monday that it will take advantage of a delay allowed companies to begin treating stock options as an expense against earnings.

In a Securities and Exchange Commission filing, RehabCare said the deferral means its 2005 financial results won't include an expected pretax expense of $4.2 million, or 15 cents a share after tax, from the change to stock-option expensing.

The St. Louis-based provider of rehabilitation program management services has said it expects earnings per share for the year to be $1.43 to $1.58, including the effect of the accounting change.

As reported, the SEC decided last week to give most companies added time to implement an accounting standard requiring treatment of stock-option expenses as a charge against earnings. Until the SEC acted, companies would have had to begin counting stock options as a compensation expense for fiscal periods beginning after June 15. Now most companies, including RehabCare, can delay the accounting change until January 2006.

RehabCare said based on the SEC's decision and potential added guidance from the accounting rulemaking body, the company will defer options expensing to "ensure that its accounting systems and reporting practices will fully comply with the standard."

I don't get it - how has the company been able to provide stock option for the footnote but not for its income statement?

When is consistency and comparability lost?

Recall that two of the qualitative characteristics of accounting information that contribute to relevance and reliability are consistency and comparability. This fiscal year is shaping up as probably having the largest number of restatements in history. What will be the result of all of these restatements on investor's ability to use the financial information? Take for instance the following press release of CSK Auto the company is delaying the release of its fourth quarter and annual financial statements because it is reviewing its lease accounting and because it may change from LIFO inventory accounting to FIFO:

"Due to our review of our lease accounting practices, as well as other matters including a potential voluntary change of inventory accounting method from the LIFO-based method to the FIFO-based method, which we are currently evaluating, our year-end financial closing process is taking longer than anticipated. As a result, we have concluded that it is necessary to delay the scheduled announcement of earnings for the quarter and year ended January 30, 2005. Additional details regarding the earnings release and conference call will be forthcoming," said Maynard Jenkins, Chairman and Chief Executive Officer of CSK Auto Corporation.

So this company could see both a lease restatement and an inventory restatement, maybe 2004 will go down as the year of lost financial relevance.

Yes or No on Stock Options

There seems to be a number of rumours in the press that there will be a delay in implementing expensing of stock options, on Bloomberg today there was a story that:

Commissioners at the SEC are voting on a staff proposal to delay implementation of the rule, which treats employee stock options as an expense, until the start of a company's first fiscal year after June 15. Under the Financial Accounting Standards Board's current rule, it would have started with the first fiscal quarter after that date.

What is the effect of the option expensing rule:
Such accounting would have reduced per-share profit among companies in the Standard & Poor's 500 Index by 8 percent in 2003, according to a study by Bear Stearns Cos.


Hopefully the SEC will not overturn the FASB's decision and investors can get a better idea of how much compensation expense is associatedx with stock options.

AIG's Annual Report

One of the many large issues swirling around the AIG case is the treatment of compensation expense paid to key AIG executives by Starr International. Starr was set up by key AIG executives when the company first went public and is basically a holding company for AIG stock, the company holds about 12% of AIG's stock. The accounting issue is that Starr provides current key AIG executives shares of Starr and AIG does not recognize any expense on its income statement. From yesterday's WSJ on AIG:

Here is why AIG's prior accounting treatment looks questionable to some accounting specialists: Under the accounting rules for stock compensation, if a principal stockholder of a company establishes a stock plan to pay that company's employees, the company must account for the payments as an expense on its own income statement.

The rules define a principal stockholder as one that either owns 10% or more of a company's common stock or has the ability to exert significant influence over a company's affairs, directly or indirectly.

It seems pretty straightforward that AIG should have recognized compensation expense related to the Starr compensation, why the company didn't is a mystery, however the information was disclosed. here is the footnote from the 2003 annual report (footnote 16):

16. STARR INTERNATIONAL COMPANY, INC. PLAN Starr International Company, Inc. (SICO) provides a Deferred Compensation Profit Participation Plan (SICO Plan) to certain AIG employees. The SICO Plan came into being in 1975 when the voting shareholders and Board of Directors of SICO, a private holding company whose principal asset consists of AIG common stock, decided that a portion of the capital value of SICO should be used to provide an incentive plan for the current and succeeding managements of all American International companies, including AIG.
Participation in the SICO Plan by any person, and the amount of such participation, is at the sole discretion of SICO's Board of Directors, and none of the costs of the various benefits provided under such plan is paid by or charged to AIG. The SICO Plan provides that shares currently owned by SICO may be set aside by SICO for the benefit of the participant and distributed upon retirement. The SICO Board of Directors may permit an early pay-out of units under certain circumstances. Prior to pay-out, the participant is not entitled to vote, dispose of or receive dividends with respect to such shares, and shares are subject to forfeiture under certain conditions, including but not limited to the participant's voluntary termination of employment with AIG prior to normal retirement age. In addition, SICO's Board of Directors may elect to pay a participant cash in lieu of shares of AIG common stock. If the expenses of the SICO Plan had been reflected by AIG, the pre-tax amounts accrued would have been $49.4 million, $55.7 million and $76.8 million for 2002, 2001 and 2000, respectively.

International accounting and Japan

There is an interesting story in the WSJ today concerning Japanese firms listed on European stock exchanges. The EU which has adopted international accounting standards is invetigating whether Japanes accounting standards are "equivalent". It appears that if the Japanese accounting standards are not found equivalent that 89 Japanese firms would be banned from the EU exchanges. The major differences between Japanese and international standards are as follows:


Mergers - still allow pooling and purchase methods
Goodwill - is not recognized unless the acquiring entity have already had investments in the stock issued by the acquired entity.
Leases - more latitude to treat leases as operating
Impairments - no recognition of impairment losses


Yoshinori Kawamura has created an excellent website about Japanese GAAP,
that anyone interested should check out.

International Pension Accounting

Pension accounting is one of the most difficult areas in financial accounting, the number of estimates that go into creating the components of expense and the projected benefit obligation plus the off balance sheet nature of the accounting can be difficult for students. Pension accounting can also be difficult for financial analysts especially when firms have new rules as in Britian. The Times of London details a study by Deloitte which examines the effect of adopting international accounting rules for pensions on FTSE 100 firms :

BRITAIN’S biggest companies face a £40 billion pensions hit this year under new accounting rules that could trigger sharp falls in share prices and force widespread restructuring, new analysis has shown.

FTSE 100 companies with final salary pension schemes have a combined pensions deficit of £50 billion under accounting standards brought in this year. However, less than £10 billion is currently booked in the accounts. There are fears that share prices could be hit when City analysts become aware of the extent of the gap.

In addition:

David Robbins, a consulting director for Deloitte, said that the full impact of the adjustment could come as a shock to financial analysts. He said: “We were very surprised to find that very little of the pensions deficit is actually in the accounts. Getting from £10 billion to £50 billion in one year is going to be a real jolt.”

Changes affecting quoted companies are required under IAS19, the new international accounting standard for pensions. The impact will start to be seen from July.

Finite Risk Insurance

It appears that one of the major issues surrounding the AIG scandal is the accounting and business transactions involving finite risk insurance. Liberty Mutual provides a reasonable overview of finite risk insurance here a brief section:

Finite risk insurance is based on the principles of financial reinsurance. It seeks to transfer the financial responsibilities associated with either known or unknown losses paid over a specific period of time. A company can purchase a finite risk policy to transfer the liabilities of future payments for losses to an insurance company.

Some of the statements in the article are a bit sketchy such as this one:

During the 1980s, changes in the property/casualty marketplace caused companies to increase their risk retentions. This generally took the forms of larger deductibles and self-insurance. As a result, many companies began to accumulate liabilities for uninsured losses on their balance sheets.

Now, after years of retaining these losses, companies are carrying a sizable number of open claims and their accompanying liabilities on their books. These mounting liabilities on balance sheets can cause problems for companies. For instance, they could depress a company's earnings or affect its ability to obtain credit. Finite risk insurance has emerged as a practical and effective tool to help companies solve the problem of mounting liabilities for a set cost during a set time.

I am not certain how the mounting liabilities could affect earnings, it seems that the hit to earnings would have already taken place?

For another perspective on Finite Risk Insurance there is a good article in The Regulator which is pu out by the Insurance Regulatory Examiners Society. The article does a good job of explaining the product and also discussing the 10/10 rule of risk transfer, i.e. to be an isnurance product there has to be a chance that 10% chance that 10% of the premium is at risk.

After reading the article you may wonder whtat to believe about earnings.
Finite risk insurance is based on the principles of financial reinsurance. It seeks to transfer the financial responsibilities associated with either known or unknown losses paid over a specific period of time. A company can purchase a finite risk policy to transfer the liabilities of future payments for losses to an insurance company.Finite risk insurance is based on the principles of financial reinsurance. It seeks to transfer the financial responsibilities associated with either known or unknown losses paid over a specific period of time. A company can purchase a finite risk policy to transfer the liabilities of future payments for losses to an insurance compan