Intermediate Accounting: Financial Reporting and Analysis Blog

Nice article for discussion of stock options

2006-04-06T09:43:00.000-04:00

A recent USA TODAY article provides a nice way to lead into the discussion of expensing of stock options. We cover the issue of stock option compensation in chapter 18 of our text. One item of interest is:

Massive charges. The change is still causing some major earnings turbulence. Merrill Lynch this week said it would expense $1.2 billion for stock options in the first quarter, vs. the $350 million previously expected. Richard Wagner, president of Strategic Compensation Research Associates, says the magnitude of that is staggering. He says accounting watchdogs eliminated a technicality Merrill had been using to delay having to expense options. Rather than taking a hit to earnings over several years, Merrill took it all in the first quarter.

Caribou Coffee's Asset Retirement Obligation

2006-04-05T16:49:00.000-04:00

When Caribou Coffee announced its recent earnings one thing that stood out was its reference to FIN 47:

Effective October 3, 2005, the Company adopted FASB Financial Interpretation No. 47 ("FIN 47") Accounting for Conditional Asset Retirement Obligations. FIN 47 requires the Company to record an asset and a corresponding liability for the present value of the estimated asset retirement obligation associated with the fixed assets and leasehold improvements at some of our coffeehouse locations. The asset is depreciated over the life of the corresponding lease while the liability accretes to the amount of the estimated retirement obligation. The Company recognized an expense for the cumulative effect of this accounting change in the fourth quarter of 2005 of $0.4 million or ($0.02) per share.

The story also presents Caribou's balance sheet, which includes the following:

Notes payable and capital lease obligations,
less current maturities - 19,923,930
Asset retirement obligation liability 760,997 -
Deferred rent liability 10,485,177 8,420,509
Deferred revenue 2,964,000 3,055,000
Minority interests in affiliates 138,159 217,206
Total long term liabilities 14,348,333 31,616,645

Software revenue

2006-04-04T15:42:00.000-04:00

Motive, Inc. disclosed in an 8-K, that it would have to restate its past financial results because of difficulty applying the software revenue recognition rules.

The discussion of the software issue demonstrates how difficult it is to apply software revenue recognition rules.

Specifically, the 8-K reported:

In its 8-K, Motive said it recently concluded that insufficient evidence existed to support the Company's prior determination that vendor specific objective evidence (VSOE) of fair value for maintenance existed for the majority of its software arrangements. Generally speaking, the presence of VSOE of fair value permits the revenue of a bundled software arrangement to be allocated among that arrangement's various elements, such as license, maintenance, consulting, and hosting services.

The absence of VSOE of fair value is expected only to impact the timing of revenue recognized and does not call into question the validity of the underlying transactions or revenue. Generally speaking, the absence of VSOE of fair value is expected to result in the recognition of revenue over longer periods of time.

Money for Nothing

2006-04-03T14:07:00.000-04:00

Home Depot reported revenue from unused gift cards. This would seem to be an interesting topic to bring before intermediate accounting students given Home Depot's rationale:

Home Depot calculated the $43 million in "breakage"—unredeemed value of cards sold—by analyzing historical redemption patterns and tallying the remaining balance of outstanding gift cards that are unlikely to be redeemed. But the cards have no expiration date or service fees, and cardholders can redeem their gift cards at any time.

Home Depot will regularly track income from unredeemed gift cards
"Our breakage reporting will never affect a customer that has an unused gift card," Smith said. "If there is a remaining balance on the card, the customer will always be able to use that card and be assured that the money is there and available for them to use in our stores."

This is interesting: Should HD recognize revenue when the cards have no expiration date?

The article goes on to detail:
About 12% of gift card value is never spent, according to research firm TowerGroup, Needham, MA. That will be about $5.7 billion in the U.S. this year, up from more than $4 billion in 2002, per TowerGroup.
Sales of retailers' gift cards will reach $47.5 billion this year; $50.8 billion in 2006; and top $57 billion in 2008, TowerGroup projects.

$5.7 BILLION in unused gift cards!!

The new Pension Exposure Draft is released

2006-03-31T10:51:00.000-05:00

The FASB released the Pension exposure draft today.

Some important items:

The Exposure draft would require:
a. Recognize in its statement of financial position the overfunded or underfunded status of a defined benefit postretirement plan measured as the difference between the fair value of plan assets and the benefit obligation. For a pension plan, the benefit obligation would be the projected benefit obligation; for any other postretirement benefit plan, such as a retiree health care plan, the benefit obligation would be the accumulated postretirement benefit obligation.

The second important point is that the standard would become effective for most companies in 2007:

Issue 4: This proposed Statement would require a public entity that currently
measures plan assets and benefit obligations as of a date other than the date of its statement of financial position to implement the change in measurement date as of the beginning of the fiscal year beginning after December 15, 2006. If that entity enters into a transaction that results in a settlement or experiences an event that causes a curtailment in
the last quarter of the fiscal year ending after December 15, 2006, the gain or
loss would be recognized in earnings in that quarter. Net periodic benefit cost in the year in which the measurement date is changed would be based on measurements as of the beginning of that year.

SOX and derivatives

2006-03-30T14:36:00.000-05:00

There is an interesting article on TCS Daily today that looks at SOX, it is interesting when compared to Jack Ciesielski blog entry for today at the Accounting Observer Blog. The TCS piece is a good example of how business people downplay the benefits of SOX and accentuate the costs. But many times SOX work has uncovered weak internal controls on basic accounting functions. Mattson Technologies 8-K is a good example, not derivatives, not Fin 46, rather it was:

In connection with the preparation and review of the Company's financial statements for the year ended December 31, 2005, management became aware that the Company's previously reported results for the first, second and third quarters of 2005 contained errors related to its recognition of revenue, assessment of inventory valuation, recording of depreciation and amortization expense for certain assets, and estimation of statutory liability for severance payments earned by certain foreign employees.

Why we still need to care about Defined Benefit Plans.

2006-02-24T12:34:00.000-05:00

When teaching pensions I sometimes think that maybe I should just give the pension expense/ Cash entry that is needed by firms that provide defined contribution plans, since it seems that no company would start (or maybe even continue) a defined benefit plan.

However, we have to remember that most companies still maintain separate defined benefit plans for highly compensated employees. These pension plans are non-qualified plans, in that they do not qualify for tax benefits but they are still provided by companies and they are quite lucrative.

A nice article about these types of plans.

Intergraph's Accelerated Share Buyback program

2006-02-09T15:39:00.000-05:00

From Intergraph's July 29, 2004 8-K:

Share Repurchase Update
On July 28, 2004, the Company repurchased 3,797,949 shares from Goldman, Sachs & Co. in a private transaction in connection with an Accelerated Stock Buyback (ASB). No trading activity has occurred in the public market related to this transaction prior to the issuance of this press release. The shares were repurchased for an upfront payment of $100 million or $26.33 per share, subject to a market price adjustment provision based on the volume weighted market trading price over the next nine months. Separately, during the second quarter the Company
repurchased 250,000 shares of its common stock through transactions on the open market for approximately $6.4 million. As a result, giving effect to the ASB, the Company has approximately $28 million remaining (subject to any accelerated buyback adjustments) under its $250 million open market repurchase program. In total, the Company has repurchased more than 20 million shares for approximately $485 million since late 2001.

Accelerated Share Buyback

2006-02-09T14:32:00.000-05:00

Buying back shares outstanding has been a pretty straight-forward accounting topic, but here is a new twist that will add to a lecture. Obviously the benefit of a stock buyback is that it reduces the number of shares outstanding (or keeps the shares outstanding constant given all of the employee stock options that are being issued). However, one problem that has occurred is that buybacks take a good bit of time and thus any boost to your EPS is not directly shown.

Accelerated Share Buyback programs are a new way of buying back a large chuck of stock all at one point in time. Here is how it works:

Company X talks to its investment bank and says that it wants to repurchase 10% of its outstanding shares. The investment bank "borrows" 10% of the outstanding shares immediatly and sells them to Comp. X. (The investment bank has shorted the stock)

This would seem dangerous for the investment bank since lower shares outstanding may lead to higher EPS which would boost the stock and make it more expensive to buy back. However, in most of these agreements the investment bank price protects itself from higher future prices by making company X reimburse it for any additional costs of buying back the stock.

This is the issue: this means that the true cost of the buyback program is not known until much later while the company is showing higher EPS right away.

Leasing, FASB and the IAS

2006-02-08T12:56:00.000-05:00

I start teaching leasing tomorrow and it is always a difficult subject for everyone. In addition, it is hard to get through to students how much of an impact the leasing standard has had on the leasing profession. There is currently before the FASB a motion to adopt the international standard on leasing, which would greatly curtail operating leasing. CFO Magazine had a good article about the how the adoption of the international accounting standard would even affect outsourcing which can be found here:

Under an accounting rule enacted in January 2004 by the International Accounting Standards Board, moreover, much of any cost savings could disappear, since companies would no longer be able to transfer any of their outsourced assets from their balance sheets to that of the service provider. That's because the contract would be considered a form of leasing, and the IASB rule won't allow assets financed by leases to be transferred for purposes of financial reporting. While the international rule won't automatically become part of U.S. GAAP, standards-setters in the United States and are bent on aligning their regimes as closely as possible (see "The Narrowing GAAP," Experts say the change could have a sizable effect on a company's reported results. "Outsourcing customers are likely to find that these new rulings have a significant impact on their balance sheets, depreciation schedules, and potentially even their earnings," Julie Giera, an analyst for Forrester Research, noted in a research report last June.

Amazon's earnings miss

2006-02-03T10:22:00.000-05:00

Amazon released its earnings last night and one of the interesting things is that the company is running out of tax benefits. It seems almost hard to believe that the company that had so many years of losses and had built up so many tax benefits is now profitable and having to pay taxes.

The Seattle-based Internet retailer said net income for the quarter ended March 31 fell to $78 million, or 18 cents a share, from $111 million, or 26 cents a share, from the same period a year ago. Profits for the latest period were affected by $56 million in income tax expense, compared with a $2 million income tax benefit in the same period a year ago.

FASB Update

2006-02-03T10:09:00.000-05:00

The FASB released information from its Jan. 18th board meeting. The meeting focused on Pensions and leveraged leases. There would be a number of changes to Pension disclosures:

The disclosure requirements of FASB Statement No. 132 (revised 2003), Employers’ Disclosures about Pensions and Other Postretirement Benefits, would be revised as follows:

The existing requirement to disclose a reconciliation of the over- or underfunded status to amounts recognized in the statement of financial position would be eliminated (paragraph 5(c) of Statement 132(R)).
The existing requirement to disclose information about a recognized additional minimum liability would be replaced with a requirement to disclose the nature and amount of changes in plan assets and benefit obligations recognized in net income and in other comprehensive income of each period (paragraph 5(i) of Statement 132(R)).
Disclosure would be required in the postretirement benefits footnote of the accumulated amount of changes in plan assets and benefit obligations that have been recognized in other comprehensive income and will be recycled into net income in future periods.
The examples in Statement 132(R) would be amended to clarify and illustrate the existing requirement to disclose the current and noncurrent portion of postretirement benefit plan assets and liabilities.
The current requirement to disclose the measurement date (if other than the reporting date) would be eliminated when the measurement date change is effective (paragraphs 5(k) and 8(j) of Statement 132(R)).
Disclosure would be required of the amount of estimated net actuarial gains and losses and prior service costs that will be amortized from accumulated comprehensive income into net income over the next fiscal year.

Google: Taxes

2006-02-01T10:17:00.000-05:00

Last night Google's earnings were announced and one of the interesting questions focused on the company's tax rate, which climbed to 41% for Q4 and increased to 31.6% for all of 2005 (Google had estimated the tax rate at 30%).

Teaching Deferred taxes is difficult as it is, but the Google conference call provides an interesting discussion that might make DT a bit more "real", here it is from the conference call:

George Reyes, Chief Financial Officer

Now I’ll turn to taxes. Our effective tax rate for Q4 increased to 41.8% this quarter and to 31.6% for the year, above expectations of approximately 30% for the year. The amount of tax expense we recognized in any particular quarter is driven by our estimates for the year. And as we’ve said in the past, our estimates for the year are sensitive to the mix of earnings in the US and overseas. These estimates are complex and 2005 was the first year we realized any reduction to our effective tax rate as a result of profits earned overseas under our international structure. At the end of the year, we must true up the tax provision for the year, which could and in the case of Q4, did have a disproportionate impact on the 4th quarter. In calculating our true up for the year, the proportion of expenses allocated to international operations was greater than we expected. Primarily as a result of this a greater percentage of our profits were taxed at a higher domestic tax rate, which resulted in a greater effective tax rate, compared to our expectations. Keeping in mind the complexity of projecting tax rates, we expect our effective tax rate for 2006 to be approximately 30%.

Teaching long term debt

2006-01-30T17:01:00.000-05:00

I sometimes find it difficult to find real world articles that make long term debt more interesting. Usually, there is discussion about the features and then pricing. However, I don't think students get a good feeling for covenants, standing and default issues. There is an article in the WSJ today (not free to link) that is really interesting and discusses a number of interesting real world bond issues:

For months, bond investors have lamented the swing by companies to shareholder-friendly practices such as stock dividends, which often lead to credit-rating downgrades and take money away from such bond-friendly pursuits as debt repayment.

At the same time, the syndicated-loan market -- debt that carries recovery claims senior to bonds -- has exploded. In some cases, that means reduced recovery prospects for bondholders because holders of bank debt have the first claim on collateral.

Bondholders are forced now to become more vigilant, keeping one eye trained on the bank debt on the top of a company's capital structure and the other on stockholders, who are growing increasingly insistent on moves that benefit shareholders.

A number of interesting issues are brought up in the article, and issues that would create a lot of intereting classroom discussion.

Will the FASB kill pension plans?

2006-01-30T14:40:00.000-05:00

There is an article in the Seattle Post Intelligencer today discussing how the FASB's intention to require full recognition of pension assets and liabilities will lead to companies killing their pension plans.

But some experts say new regulations requiring companies to more accurately calculate and show the cost of their retirement promises could speed up the move by employers away from guaranteed pensions and other benefits.

"Changing accounting rules can cause companies to change their behavior," said David Zion, an accounting analyst with Credit Suisse First Boston.

Everyone really should read this entire article. Once again we seem to be going back to the economic consequences argument. I always like to discuss these types of issues with my students to get their opinions on disclosure and measurement issues.

Maybe its not accounting that is doing this but rather short- sighted managers who do not see their employees as partners. I wonder how many of the firms who will end their general pension plans (open to all employees) will maintain their pension plans for high level executives?

For another take on this debate read Slate's article by Daniel Gross: The Cram Down Decade

FASB - IAS convergence

2006-01-30T14:31:00.000-05:00

An Accountancy Age article reports the recent fair value proposal by the FASB:

The FASB today moved a step further along its IFRS convergence journey with a proposal that would allow companies the option of reporting financial assets and liabilities at fair value.

The article goes on to provide this information:

The FASB added that the change would simplify accounting and reduce earnings volatility caused by differences in current accounting rules.

If implemented, the new standard will allow financial assets and liabilities to be measured at fair value on a contract-by-contract basis. Companies will have to display these values separately from those measured under different attributes on the balance sheet.

I wonder how having an accounting fully based on market value principles would lead to reduced earnings volatility? It would seem to me that mark to market accounting would only lead to more volatility as the changes in interest rates, market values etc. would create a lot of variability.

The new restatement issue

2006-01-27T15:01:00.000-05:00

There is an interesting article in the Wall Street Journal today (subscription required) about the number of restatements occuring due to firms' misunderstanding of the requirements necessary to qualify a transaction for hnedging treatment:

Hedge accounting is complex, but the goal is easy to understand: When a company uses derivatives to hedge exposure to risks like changes in interest rates and fluctuations in foreign currencies, it wants those derivatives to qualify for hedge-accounting treatment under accounting rules because any changes in the derivatives' value can be excluded from current earnings. The value changes are "smoothed" into earnings over time. Without that special accounting status, the derivatives' ups and downs would make earnings unpredictable, which companies and shareholders dislike.

To qualify for hedge accounting, however, companies have to meet a strict set of criteria. And dozens have discovered lately that either they haven't fully complied or have cut corners they shouldn't have. Some have found their hedges don't do the job they're supposed to in offsetting the changes caused by the risk they're hedging. Others don't have sufficient documentation for their hedges.A

A number of companies are filing non-reliance 8-Ks because they have used the short cut method without ever having checked for hedge effectiveness in the firstplace. Here is the 8-K from Great Southern Bancorp. Remember one of the keys to applying the shortcut method is the that the features of the hedge match precisely the features of the instrument being hedged (i.e. there is no value at initiation):

On January 18, 2006, management and the Audit Committee of the Board of Directors of the Company determined that the Company's financial statements as of and for the quarters ended March 31, 2005, June 30, 2005 and September 30, 2005, and as of and for the years ended December 31, 2004, 2003, 2002 and 2001, should no longer be relied upon as a result of the accounting treatment applied by the Company in connection with certain interest rate swaps associated with brokered CDs.

Since mid-2000, the Company has entered into interest rate swap agreements to hedge the interest rate risk inherent in certain of its brokered certificates of deposit (CDs). From the inception of the hedging program, the Company has applied a method of fair value hedge accounting under Statement of Financial Accounting Standards ("SFAS") 133 to account for the CD swap transactions that allowed the Company to assume the effectiveness of such transactions (the so-called "short-cut" method). The Company has recently concluded, in conjunction with BKD, LLP, its independent registered public accounting firm at all relevant times, that the CD swap transactions did not qualify for this method in prior periods because the method to pay the related CD broker placement fee was determined, in retrospect, to have caused the swap to not have a fair value of zero at inception (which is required under SFAS 133 to qualify for the "short-cut" method). Although the impact of applying the alternative "long-haul" method of documentation using SFAS 133 and the results under the "short-cut" method are believed to result in no significant difference in the hedge effectiveness of the majority of these swaps, and management believes these interest rate swaps have been effective as economic hedges, hedge accounting under SFAS 133 is not allowed for the affected periods because the proper hedge documentation was not in place at the inception of the hedge.

The Company is charged a fee in connection with its acquisition of brokered CDs. This fee is not paid separately by the Company to the CD broker, but rather is built in as part of the overall rate on the interest rate swap. In connection with the restatement, the Company has determined that this broker fee should be accounted for separately as a prepaid fee at the origination of the brokered CD and amortized into interest expense over the maturity period of the brokered CD. If the Company calls the brokered CD (at par) prior to maturity, the remaining unamortized broker fee is expensed at that time. The remaining unamortized prepaid broker fees related to these brokered CDs at December 31, 2005, were $6.5 million.

International standards gain another partner

2006-01-26T13:47:00.000-05:00

It appears that South Korea will adopt International Financial Reporting Standards starting in the second half of 2006.
"The preparatory body will hold monthly meeting starting next month to check the issues at hand," said Kim Yong-hwan, a director at the commission. "The commission formed the body to fit our accounting principles to international standards without giving any shock to local companies."

The pressure on the US, Japan and Australia will continue.

Hello

2006-01-23T16:58:00.000-05:00

Hello, I am back from hiatus and will be back to blogging tomorrow.

Where is the harmonization?

2005-10-24T11:29:00.000-04:00

Maybe the move to international standards won't be so easy. Here is an article from Accountancy Age discussing European criticism of proposed standard IFRS#3 (here is a link to the US Exposure draft). Much of the criticism regards the inclusion of fair value accounting into the measurement process.

The European Financial Reporting Advisory Group (Efrag) has drafted a letter to the IASB expressing 'major concerns' over ammendments to IFRS3. It says the new standard would introduce unreliable fair value measurements, and claims that standard-setters are changing their approach without prior discussion.

Efrag's concern is that the IASB and FASB are seeking to reinvent financial reporting with new rules rather than harmonise the existing standards.

The new standard would have major effect on post-transaction earnings per share as a result of M&A activity. This is a key measure of a deal's success, and would lead to drastic changes in the balance sheet of acquirers.

Flu vaccine shortage due to revenue recognition rules?

2005-10-21T13:19:00.000-04:00

When I saw the WSJ headline "Death by Accounting" I was skeptical that accounting was somehow responsible for the flu vaccine shortage. The artticle discussed the ramifications of SAB 101 on bill and hold revenue recognition issues. The vaccine industry is an excellent example of a bill and hold situation, vaccine companies receive a lot of money upfront in payment for vaccines that will be sent out later. However the revenue for these prepaid vaccines can not be recognized until the vaccines are "delivered".

I am still skeptical after reading the article. Companies increase value by taking on positive NPV projects not because they recognize revenues this period as oppossed to a later period. In fact some of the quotes in the article are just plain wrong, take for example:

The upshot of this policy is that no matter how much cash the government puts in vaccine-makers' hands for making drugs for the stockpile, they cannot include this money in their official sales until it is actually delivered to doctors when and if there is a disease outbreak. This period can last more than a year. While one part of government is urging manufacturers to have a reserve on hand for a flu outbreak, another is telling them that they won't show any gain on their books for doing so. In fact, companies that contribute to the stockpile will take a paper loss for this part of their business, because the SEC is not about to let them postpone "recognition" of their costs of making the vaccines. And because of other regulations and trial lawyers always eager to pounce on "deceptive" accounting, it is difficult for companies to communicate with investors about this distorted earnings picture.

Is the author really suggesting that if a drug company explained to its shareholders the revenue recognition policy behind the stockpile program and clearly disclosed it in its financial statements that it would be sued for "deceptive" accounting?

I am still skeptical. I imagine what the SEC wants to prevent is a drug company that is not going to meet its earnings number dump a bunch of vaccines into the national stockpile so that it can recognize revenue.

A classroom discussion about ethics

2005-10-21T13:12:00.000-04:00

One item that I don't remember seeing when I was an accounting student was a news story about an accounting partner denied bail and under indictment. An article on WEBCPA discusses the case of David Greenberg, the KPMG partner indicted by the federal government as part of the investigation into unlawful tax strategies.

David Greenberg, 46, was one of 10 former KPMG executives indicted Monday in connection with the design and marketing of alleged phony tax shelters, and was the only defendant to be arrested by authorities. Greenberg has been accused of falsifying documents to hide his involvement in questionable tax shelters, coaching a co-conspirator to lie to investigators and misleading investigators about whether he had surrendered all his passports.

This story allows for a good discussion of ethics in the accounting profession.

international standards

2005-10-20T12:12:00.000-04:00

There is an interesting article on FT.com which examines the effect of public companies in England adopting international standards and what that means for private companies. Currently, UK standards do not harmonize with international standards so there is a situation in which two competitors,one public, one private, may be accounting for similar transactions in a different manner. The UK standard setters goal is to harmonize with international standards over time but what happens in the mean time? In addition, the article states that there are three issues that are casting doubt about harmonization:

There was widespread agreement with this and, in 2004, the first of these "convergence" standards appeared. But three developments have since clouded the consensus.

One was the agreement by the International Accounting Standards Board to start a separate "small and medium-sized enterprises project", aimed at developing a separate set of standards suitable for private companies.

The second factor was the ASB's proposal to extend the application of its financial instruments standard FRS26 (the effective equivalent of the infamous IAS39) to all entities using full UK standards. It seemed strange to make UK private companies apply a version of IAS39 when even large listed companies were complaining about its onerous requirements. This convinced many that convergence of this sort might not be what was needed.

Finally, reinforcing this unease was the IASB's own proposals to converge with US GAAP. This seemed to be importing lengthy and elaborate rules, based on some new and unfamiliar concepts.

These factors will also come into play when (and if) the US adopts international standards.

R&D spending

2005-10-19T15:15:00.000-04:00

There is an interesting article inUSA Today concerning recent cutbacks in R&D spending by various companies. The article states:

Spending on R&D by companies in the benchmark S&P 500 index has grown 3.3% over the past four quarters, well below the 11.6% growth in revenue during the same period, S&P says.

The article also cites a recent study by the consulting firm Booz Allen Hamilton that discusses the link between current R&D spending and future profitability.

A new study by consultant Booz Allen Hamilton encapsulates these fears. It found that big R&D spenders don't get returns on their outsized investments and that R&D spending has no effect on growth, profitability or shareholder return. R&D is "a roll of the dice of what you will get back," says Barry Jaruzelski, vice president of Booz Allen and co-author of the study that looked at 1,000 companies going back six years.

I always enjoy the discussion among students on the question of expensing versus capitalization of R&D. They recognize the link to future profits, but also understand the accounting reason for expensing. I try to get them to some middleground or why can't we as accountants be comfortable with not being able to exactly measure the the future linkage.

Profiting from Sarbanes-Oxley

2005-08-05T12:49:00.000-04:00

An article on SmartMoneydiscusses the price performance of Resources Global Professionals a financial consulting company that has profited greatly from Sarbanes-Oxley. The company has been doing extremely well over the last 12 months and gives a solid forecast for the future:

But one comment sheds particular light on the company's continued success: "Fiscal 2005 saw the expansion of many client relationships with companies who initially became familiar with Resources for Sarbanes-Oxley compliance efforts, but have extended their work with us into other core business areas."

Cross-selling, in other words. And Resources is still doing plenty of compliance and audit work for foreign companies, as well as companies that are trying to resolve problems that initial audits uncovered. That reflects pretty cleanly an observation from CIBC analyst Thatcher Thompson that we mentioned in our last story, that "upfront compliance is revealing shortcomings at many companies that will involve other projects to fix."

I assume that this is also good news for the other accounting firms and consulting companies (althought the shares of Accenture have been basically flat for the past 18 months).

The next round of Sarbanes-Oxley may result in less work, but be more specialized. Deloitte in a recent newsletter stated the following:

Many financial institutions are evaluating next steps in their 404 programs. Some are sitting back and waiting until next year to repeat the cycle of testing and evaluation of their internal controls. Others are taking the lessons learned and using them to implement new processes and modify system shortcomings. For several reasons, we believe the latter approach is far more prudent.
First, Section 404 is more than a pass/fail test of controls. The misleading implication of viewing Section 404 in this way is that a firm that passes has nothing to worry about. But this might not be the case. A pass does not necessarily mean that all is right with a firms risk management program. By its nature, compliance and reporting can never be entirely fail-safe. 404 programs will require constant fine-tuning and vigilance.

Stock buybacks

2005-08-04T08:02:00.000-04:00

There is an interesting article at Investor's Business Daily about the amount of stock buyback programs announced year to date. The article states that more buyback programs are resulting in fewer shares outstanding as opposed to simply netting out the added shares of option programs:

"Earnings this quarter came in above expectations. The sheer scope of cash in the corporate coffers is quite impressive," said Richard Peterson, market strategist for Thomson Financial.

By buying back shares, companies give an instant boost to their earnings per share, since there are fewer shares outstanding.

Also, by diminishing the supply of shares, they can raise the price if demand remains the same.

In actual practice, most buybacks are used to offset stock option grants to employees or dilution from acquisitions. So they don't truly reduce share counts.

But that's changing, said Howard Silverblatt, equity analyst with Standard & Poor's.

In the first quarter, 34% of buybacks were used to reduce shares, he said. That's way up from the fourth quarter's 22%, which is the long-term average.

I had a post a bit ago about Autozone and its buyback program and how it has affected the company's reported EPS. Companies are paying a high price to boost EPS. This was also crux of the issue with Altera and its treatment of Wells Fargo analyst Ted LaFountain (for a recap click here).

Microsemi's acceleration of options

2005-08-01T10:51:00.000-04:00

In a press release today Microsemi's board of director's stated that it had accelerated the vesting of all of its 8.2 M (note that "only" 35% are held by executive officers and directors, geez why not just leave open the company safe) stock options in order to avoid stock compensation expense under SFAS 123(r). The release goes on to state:

Microsemi took the action in the belief that it is in the best interests of stockholders to minimize future compensation expense, and this was the purpose of the vesting acceleration. Upon Microsemi's planned adoption of FASB Statement No. 123 R, "Share-Based Payment," effective for fiscal year 2006, vesting of unvested options will add to Microsemi's compensation expense. Therefore, we accelerated vesting into fiscal year 2005 before the new accounting rule takes effect.

Stock options are granted for numerous reasons: one being to align employees interests with those of stockholders, but if a company is just giving them away what is the point?

The chairman of Microsemi stated:
Microsemi's Chairman Dennis R. Leibel commented, "We believe that the accelerated vesting of these options is in the best interests of Microsemi and its stockholders, as this action will avoid a significant non-cash compensation expense in future periods and has minimal net effect on the optionees."

Chris Cox goes before the Senate

2005-07-29T08:23:00.000-04:00

Chris Cox was questioned by the senate yesterday and the big news (at least to an accountant) was his statement that he would support the FASB's stock option standard. This is from the Jurist:

Corporations and securities brief ~ SEC nominee Cox grilled by Senate committee
James Murdock

[JURIST] Leading Tuesday's corporations and securities law news, President Bush's nominee to head the SEC, Rep. Christopher Cox [congressional profile], told the Senate Banking Committee [official website] Tuesday that he would vigorously enforce securities laws. Cox also pledged to enforce the controversial Financial Accounting Standards Board [official website] (FASB) rule requiring companies to count stock options given to employees as a business expense. As a congressman, Cox had introduced a bill intended to limit the SEC's power to force companies to comply with the rule.

Google's stock option accounting

2005-07-28T11:08:00.000-04:00

There is a very good article in the WSJ today (subscription required) by David Gaffen about Google's quarterly reporting and share based compensation expense. I have written about this before here . My own view is that Google is purposely confusing the situation in order that amount of the company's going forward stock option expense is difficult to calculate, Why because the number is very large.

However, I do not think that analysts fully understand what is going on with the two types of option expense that Google has and how they have amortized out the pre-ipo intrinsic expense.

Becoming an accountant sure used to be easy!

2005-07-01T12:26:00.000-04:00

Old matchbook cover

KPMG

2005-06-16T10:32:00.000-04:00

The Wall Street Journal today discusses the possible indictment and criminal charges against KPMG (here is a reuters story). The story quotes KPMG's press release about the charges which states the folowing:

KPMG takes full responsibility for the unlawful conduct by former KPMG partners during that period, and we deeply regret that it occurred.

In order to ensure that this type of conduct does not occur again, KPMG has taken the following actions:

* We no longer provide the services in question.

* We have put in place a process to ensure that those responsible for wrongdoing have been separated from the firm.

* KPMG has instituted firm-wide structural, cultural and governance reforms to ensure the highest ethical standards.

* KPMG has undertaken significant change in its business practices.

So KPMG admits that it acted unlawfully, that certain of its partners (as late as 2002) obstructed justice. The funny thing is that when you look at KPMG's website this morning there is not one statement about the charges. The only thing that shows up is links to KPMG's survey of ethics and corporate responsibility. It is doubtful that the US could stand to lose another large audit firm, but it seems rather congruent when you think about what happened to Andersen and now what is happening to KPMG - Employees lost jobs, partners lost entire savings, so what will happen to KPMG?

Pensions

2005-06-08T14:40:00.000-04:00

The airline industry and its pension plans have been the subject of hearings on Capitol Hill and of course accounting is the major issue. Pension accounting is difficult enough for accountants, but put in the hands of politicians and there can be real problems. This does not excuse accountants who should be embarrassed by the pension standard.

Here are some comments from the L.A. Times :
Sen. Charles E. Grassley (R-Iowa) on Tuesday said United took advantage of accounting loopholes to meet the legal requirements for its pension plan, even though funding was falling far short of demands. One such technique is known as "smoothing," which allows companies to project past financial gains into the future, creating a false picture of a fund's stability.

Grassley compared United's pension bookkeeping to with the "phony accounting" of Enron Corp. but added that there was "a very significant difference: Unlike Enron, however, everything United did was perfectly legal. In fact, what the company did is accepted practice by pension plans everywhere."

Sentiment is growing in Congress to force changes to strengthen the pension system, but it is far from clear what measures will be adopted. Moreover, too-tough legislation could lead more companies to abandon pensions because they are under no obligation to provide them.

However there is no reason that many companies should not have done a better job funding their pension plans. Right now we are examining Anheuser Busch in my core MBA class and even this company that is a cash machine is underfunded by $705M (up from $640), when comparing the projected benefit obligation to the fair value of plan assets. Now of course Bud shows prepaid pension cost asset of $527M as a result "unrecognized net acturial losses" and "unrecognized prior service costs" that total $1.2B. Only accountants could make acturial losses into an asset component...

During this period when Bud's pension plans were becoming severely underfunded (the underfunding represents 24% of the projected benefit obligation) the board of director's has made contributions of only $187M, $75M and $201M. So even though Bud made an accelerated payment during 2005, the plan became even more underfunded. What makes this even worse is that Bud has repurchased $6 B dollars of treasury stock over the last three years. By diverting 10% of these resources to its "most valuable assets" Bud could ensured that its pension plans were in much better shape.

Accountants are King of the job market

2005-06-06T14:52:00.000-04:00

Sarbanes-Oxley (or the Accountants Full Employment Act) seems to have worked, accountants are incredible demand. Based on this Reuters' story hiring has started early and the firms are offering money and incentives:

Glover said Ernst & Young is looking to hire 4,500 accounting graduates this year, up 30 percent from last year. To lure new hires, it has boosted benefits -- including a concierge service for employees too busy to run errands.

"(Graduates) are in a very competitive space right now where you have lots of opportunities and choices of where you go to start your career," Glover said.

Concierge service!! Wow, ping-pong tables are mentioned also :)

Go Retro

2005-06-02T12:14:00.000-04:00

The FASB released Statement 154 today which requires that accounting changes be handled retroactively (unless impracticable). The big changes form Opinion 20 are that changes in depreciation or amortization method are changes in estimates (that is affacted as a change in accounting principle, i.e. restate prior periods) and

Statement 154 carries forward many provisions of Opinion 20 without change, including the provisions related to the reporting of a change in accounting estimate, a change in the reporting entity, and the correction of an error. Statement 154 also carries forward the provisions of Statement 3 that govern reporting accounting changes in interim financial statements.

Statement 154 becomes effective for fiscal years beginning after Dec. 15, 2005.

Berkshire Hathaway's dollar bet

2005-06-02T11:41:00.000-04:00

Lately, the dollar has been appreciating against the Euro, taking a look at the this graph and you can see that the dollar has moved from a low of about .73 Euros at the end of 2004 to about .82 Euros. One of the biggest bettors of a continued decline in the value of the dollar is Warren Buffett and his company Berkshire Hathaway. At the end of 2004 owned approximately $21.4 billion dollars of foreign exchange contracts (spread among 12 currencies). Given that 2004 saw a steady decline in the value of the dollar of about 12-14% Berkshire racked up large gains on its foreign currency forward contracts. From the annual report Berkshire reported $1,839 M of gains. However, since the votes in France and the Netherlands the dollar has been on a tear. What does this mean for Berkshire?

In the first quarter Berkshire reported $307M in foreign currency losses (go to page 19 of the document). And this is prior to the dollar really starting to appreciate, if the last month's trend continues second quarter losses could be about $1B.

Just something to think about.

Is this a good use of company resources?

2005-05-26T13:48:00.000-04:00

Last year the FASB released Emerging Issues Task Force Issue No. 04-8, "The Effect of Contingently Convertible Instruments on Diluted Earnings per Share," which became effective on December 31, 2004. EITF 04-8 requires that the calculation of diluted earnings per share of common stock reflect shares issuable under contingently convertible debt regardless of whether the contingent feature has been met.

This resulted in AGCO , a global manufactucturer of ag equipment deciding that it is better to spend money getting rid of its old debt and replacing it with essentially equal debt, but debt that is not subject to EITF 04-8. Here is the important portion of the release:

May 26, 2005--AGCO Corporation (NYSE:AG - News), a global manufacturer and distributor of agricultural equipment, announced today that it has filed a registration statement with the Securities and Exchange Commission to register its offer to holders of its $201,250,000 outstanding principal amount of 1 3/4% Convertible Senior Subordinated Notes due 2033 (the "Old Notes") to exchange the Old Notes for an equivalent principal amount of its 1 3/4% Convertible Senior Subordinated Notes, Series B, due 2033 (the "New Notes"). The New Notes provide for (i) the settlement upon conversion in cash up to the principal amount of the converted New Notes with any excess conversion value settled in shares of AGCO common stock, and (ii) the conversion rate to be increased under certain circumstances if the New Notes are converted in connection with certain change of control transactions occurring prior to December 10, 2010, and otherwise are substantially the same as the Old Notes.

The conversion settlement feature of the New Notes will result in the inclusion of fewer shares in the calculation of diluted earnings per share than the Old Notes, since exercise of the conversion feature would result in a payment of cash, rather than shares, for the principal amount of the New Notes.

This type of behavior can't inspire confidence.

Autozone and EPS

2005-05-25T11:27:00.000-04:00

Autozone reported higher than expected quarterly EPS numbers today.

The Memphis, Tenn., aftermarket seller of automotive parts (AZO) posted earnings of $147.8 million, or $1.86 a share, for the quarter ended May 7, up from $143.4 million, or $1.68 a share, a year earlier.

Results for the year-ago quarter included a warranty-related gain of about seven cents a share.

Sales reached nearly $1.34 billion in the period, off 1.6% from the prior year's $1.36 billion, in what CEO Bill Rhodes called a "considerably weaker" performance.

The average estimate of analysts polled by Thomson First Call was for earnings of $1.80 a share on revenue of nearly $1.38 billion.

One item that is interesting is that the company repurchased 3.2 million shares during the quarter:
In addition, the company noted its repurchase of 3.2 million common shares at an average price of $87 during the latest quarter, amounting to $278.6 million.

So what was the effect of this treasury stock transaction on EPS? In the second quarter Autozone's weighted average shares outstanding were 80,860,000 in the current (third) quarter that total dropped to 79,494,000. By repurchasing 3.2 million shares during the period Autozone increased its quarterly EPS by $0.03 . Here is the calculation:

Third quarter net income = $147.8 M
Third quarter weighted average shares outstanding (diluted) = 79,494,000
Third quarter diluted EPS = $1.86

Now instead divide by 80,860,000 shares (the weighted average shares at the end of the second quarter) and you get $1.83.

Its important to understand the effect treasury stock repurchases have on EPS calcualtions. In fact if you compare this quarter's results to a year ago when Autozone had weighted average shares outstanding (diluted) of 85,202,000 the improvement does not look that great.

Maxtor's Inventory Error

2005-05-25T11:17:00.000-04:00

When I discuss inventory errors it is always in a mechanical sense if inventory is overstated then cost of goods is understated, etc. We very seldom have a real world example of this type of situation. However, Maxtor disclosed yesterday that it had made just this type of error. In an 8-K filing the company announced that it had simply reversed an end of period adjustment to inventory. Here is the relevant part of the announcement:

Maxtor Corp. (MXO) said Tuesday that it will restate its financial statements for its first quarter ended April 2, after it discovered a data entry error related to inventory and cost of goods sold in its previously issued first-quarter financial statements.

As a result of the data entry error, inventory at April 2 was understated by $4 million, cost of goods sold was overstated by $4 million, the net loss for the quarter was overstated by $4 million and the net loss per share for the quarter was overstated by 2 cents a share, according to a Form 8-K filed with the Securities and Exchange Commission.

This is the type of item I like to bring into the classroom to get students dicussing what might have happened, what is the effect on the share price, how could this type of error have been made.

Is accounting too complicated?

2005-05-24T10:28:00.000-04:00

There was an interesting speech given by Robert Herz, the FASB's chairman at the AICPA's spring council meeting. In the speech, Herz suggested that the current literature is too complicated and that it is time to get to work on the FASB's long-term codification project:

"There's a lot of cross-currents in the profession and water coming out of a lot of places in terms of accounting standards," Herz said during the opening session of the three-day confab. "The question is what do we do with this morass of accounting literature?"

Herz outlined the profession's need to codify GAAP, and outlined FASB's multi-year codification project, where existing standards would be restructured by topic and accompanied by all relevant literature.

Herz also stated:

"Auditors have become tired and strained and there's a real fear of second-guessing," Herz said. "It's come to the point where they're saying, 'Just give me a rule.'"

What does this suggest for accounting education? How should we go about teaching accounting when it appears that we want principles but end up wioth standards?

Once again - Accountants are cool!

2005-05-23T11:01:00.000-04:00

From a story in the Seattle Times:

The bean counters have arrived. After years of operating under the shadow of the legal and investment-banking industries, the plain-vanilla world of accounting suddenly has more sex appeal.

...

As the industry basks in its newfound glory, auditors and accountants are in short supply nationwide. It takes longer to find and hire them, and salaries in a number of specialties have moved up briskly.

"The business is out there. The bigger issue is finding good people. We're always looking for qualified people," said Richard Preston, a managing partner and a certified public accountant at a Miami Beach CPA firm.

Abercrombie's inventory problem

2005-05-20T10:43:00.000-04:00

I like using popular companies like Abercrombie and Fitch in classroom discussions. Today the company reported that its first quarter earnings increased 33% over the prior year's quarter. This would seem like excellent news and student's would probably think that the stock price would go up, however here is the 2-day chart:

Abercrombie's price performance

Here is Abercrombie's unaudited partial balance sheet at the end of the quarter:
Abercrombie & Fitch Co.
Condensed Consolidated Balance Sheets
(in thousands)

(unaudited)
ASSETS April 30, 2005 January 29, 2005

Current Assets
Cash and Cash Equivalents $136,578 $350,368
Marketable Securities $177,174 -
Receivables 32,284 26,127
Inventories 227,205 211,198
Store Supplies 38,944 36,536
Other 27,844 28,048

Total Current Assets 640,029 652,277

No specific details are provided in the press release, but it is interesting that a $16 million dollar increase in inventory can result in a 15% stock price decrease.

A restatement involving Cash?

2005-05-17T17:20:00.000-04:00

Sometimes it seems like it is difficult to find anything to talk about when discussing Cash. I mean cash is cash and cash equivalents and now lets move on to accounts receivable. However, GSI Commerce is a tech company that has discussed its cash balance in a number of its press releases, I assume to show the company's fiscal strength. However, it now appears that maybe that the company's cash equivalents really weren't equivalent. In an 8-K filing GSI stated that:

In its press release dated April 27, 2005, GSI Commerce, Inc. (the "Registrant") reported that it had reclassified $6.3 million from cash and cash equivalents to marketable securities as of January 1, 2005. As discussed below, as of January 1, 2005 and January 3, 2004, the Registrant expects to reclassify $36.5 million and $18.8 million, respectively, from cash and cash equivalents to marketable securities. Additionally, in its press release dated April 27, 2005, the Registrant reported cash and cash equivalents of $11.7 million and marketable securities of $31.5 million as of the quarter ended April 2, 2005, instead of $10.7 million and $32.5 million, respectively.

Before the restatement GSI reported $56.5 M in cash and after will report $20 M. It is difficult to imagine that the company's auditors would have an issue with this topic. I wonder what the controversy was in the audit process. Maybe we will see in a lawsuit.

SRS Labs - What kind of mistake is this?

2005-05-12T16:25:00.000-04:00

SRS Labs reported that is was going to restate its 2004 results because of the way it treated costs associated with trade shows.

The restatement will increase sales and marketing expenses in periods when it attended trade shows, while lowering such expenses in other periods in fiscal 2004, the company said. As a result, the restatement will reduce SRS's previously reported earnings in the first two quarters, and increase earnings in the year's second half SRS reported restated earnings to break even per share, down from a previously reported 1 cent per share, for the first quarter, and to a penny per share, down from a previously reported two cents per share, in the second quarter.

Previously, SRS Labs capitalized costs associated with trade shows. I just don't understand under what circumstances justified a capitalization of trade show costs. I can't believe that there is not more to this issue than is being reported. I wonder if bonuses are involved.

Cisco and stock options

2005-05-11T14:02:00.000-04:00

There is an interesting article on Bloomberg today concerning Cisco's decision to try to launch a new derivative security that will have employee stock option like properties. John Chambers, Cisco's CEO has been a huge opponent of stock option accounting and believes that models place to high of a value on stock options. Chambers is trying to come up with a new security because no market prices currently exist for employee stoick options.

The expensing rule, passed by the U.S. Financial Accounting Standards Board in December, also encourages companies to value the options using an ``observable market price.'' Unlike call or put options that trade on exchanges such as the International Securities Exchange, employee stock options can't be bought or sold, so there is no market.

Cisco's derivatives would function under the same terms as its employee stock options, including the same exercise prices and five-year vesting schedule. They would be sold once and couldn't be traded or hedged. Settlement of any gains would be with Cisco shares.

Powell told SEC officials that Cisco wants to begin selling the derivatives as early as August and the company would need 15 buyers to create a proper market, the people familiar with the meetings said. Earnhardt declined to comment on timing of any sale. Melissa Stonberg, a spokeswoman for Morgan Stanley, declined to comment.

Cisco must begin deducting the cost of employee stock options from earnings in the first quarter of its fiscal year, which starts in August.

2005-04-29T12:35:00.000-04:00

First Edition

SEC to provide guidance on error correction.

2005-04-28T16:06:00.000-04:00

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)

2005-04-27T12:07:00.000-04:00

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

2005-04-20T10:33:00.000-04:00

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

2005-04-19T18:35:00.000-04:00

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

2005-04-18T17:09:00.000-04:00

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?

2005-04-14T10:44:00.000-04:00

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

2005-04-13T15:13:00.000-04:00

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

2005-04-12T11:21:00.000-04:00

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

2005-04-05T12:25:00.000-04:00

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

2005-04-04T14:55:00.000-04:00

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

2005-04-01T10:25:00.000-05:00

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

Ethics and accounting

2005-03-30T10:50:00.000-05:00

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

2005-03-29T09:03:00.000-05:00

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.

``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

2005-03-28T14:53:00.000-05:00

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

2005-03-25T09:51:00.000-05:00

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

2005-03-22T09:54:00.000-05:00

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

2005-03-21T12:22:00.000-05:00

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

2005-03-16T11:43:00.000-05:00

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

2005-03-14T14:53:00.000-05:00

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

2005-03-14T11:07:00.000-05:00

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

2005-03-14T11:04:00.000-05:00

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

2005-03-07T10:02:00.000-05:00

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.

2005-03-04T12:12:00.000-05:00

The importance of knowing accounting...

2005-02-28T20:18:00.000-05:00

One of the more interesting items that has come out of the Bernie Ebbers case is his claim that he does not understand accounting. In a description of his testimony Ebbers is reported to have:

"....admitted he was a demanding and sometimes temper-prone boss at WorldCom, but he repeatedly said he was unfamiliar with the details of finances and accounting, and left the numbers-crunching to Sullivan."

The accounting issue that has caused Worldcom so much trouble is simply the capitalization of maintenance and line costs. Students in intermediate financial accounting understand the basic issue of capitalization versus expensing, it is difficult to believe that Ebbers did not grasp this basic issue.

Cash Flow Statement and Inventory Financing

2005-02-24T09:57:00.000-05:00

An interesting development from the SEC that is applicable to the cash flow statement and inventory chapters.

The SEC is cracking down on companies that are "Presenting cash flows between the company and/or its consolidating subsidiaries as an investing cash outflow and an operating cash inflow when there has not been a cash inflow to the company on a consolidated basis from the sale of inventory..."

From the SEC:
In January 2005, the staff of the Division of Corporation Finance sent
letters to certain registrants related to their presentation of cash
receipts from inventory sales in their consolidated statements of cash
flows. In order to affect wide-spread awareness of this issue and to
refocus registrants on the proper presentation in their consolidated
statements of cash flows, we are providing publicly an example of
comments that registrants should consider as they prepare future
Commission filings.

The importance of appropriate classification and presentation of items
in the consolidated statement of cash flows cannot be overstated. The
statement of cash flows is one of the primary statements required with a
full set of financial statements. It is relied upon by analysts and
investors as much, if not more in some instances, as the statement of
net income. As such, we expect registrants to give significant attention
to the preparation of their consolidated statement of cash flows in
order to ensure it provides an accurate presentation of their actual
cash receipts and cash payments based on activity (operating, investing
and financing), which in turn assists the reader in determining the
registrant's ability to meet its obligations, pay dividends, generate
cash flows sufficient to grow its business, etc. While the staff
believes a statement of cash flows using the direct method provides
investors with more useful information than the short-cut indirect
method, we recognize that most companies use the indirect method.
Therefore, we encourage companies to put more time and effort into
ensuring that the statement of cash flows, and related disclosure in the
financial statement footnotes and in MD&A, is meaningful and useful to
users of the financial statements.
-Curt Norton

GenCorp and government contracts

2005-02-23T12:22:00.000-05:00

There is an interesting article in the Wall Street journal today concerning how GenCorp recognizes reimbursements from government contracts. GenCorp is a defense contractor which owns a subsidiary called Aerojet. Aerojet makes propulsion systems for the Patriot and Tomahawk missile systems. However, Aerojet also created a large environmental pollution problem. From the Wall Street Journal article we find out:

The federal government in a 1999 settlement agreed to cover up to 88% of Aerojet's environmental cleanup costs in the form of future contracts.

Because of this GenCorp records a current asset for future recoverable amounts from the Government for cleaning up polluted sites. Here is the relevant information from GenCorp's footnotes:

The Company recognizes amounts recoverable from insurance carriers, the U.S. government or other third parties, when the collection of such amounts is probable. Pursuant to U.S. government agreements or regulations, the Company can recover a substantial portion of its environmental costs for its Aerospace and Defense segment through the establishment of prices of the Company’s products and services sold to the U.S. government. The ability of the Company to continue recovering these costs from the U.S. government depends on Aerojet’s sustained business volume under U.S. government contracts and programs (see Note 13).

Note 13 is the company's contingencies footnote which is 6 to 7 pages long. The relevant information about Aerojet is on page 91. The question is whether a company should recognize a receivable for future recoverable amounts when those amounts are not certain.

accounting and stock options

2005-02-21T12:15:00.000-05:00

On Saturday there was a story on Marketwatch.com concerning Time Warner's decision to stop issuing stock options as compensation to MOST OF ITS employees. The article provides the following information:

The media giant said Friday that new financial reporting standards that require companies to treat stock options as expenses make it "prohibitively expensive" to grant the options to all employees, according to a New York Times report.

Time Warner said it will continue to grant stock options to some workers based on their job responsibilities and industry practice.

The accounting change for stock options can be summed up by this statement by the FASB about the revised standard for stock options (FAS 123R):

As stated by the FASB, "FAS 123R will provide investors and other users of financial statements with more complete and neutral financial information by requiring that the compensation cost relating to share-based payment transactions be recognized in financial statements. That cost will be measured based on the fair value of the equity or liability instruments issued. This Statement is the result of a two-year effort to respond to requests from investors and many others that the FASB improve the accounting for share-based payment arrangements with employees."

The change in accounting simply requires that companies that once disclosed the cost of stock options in the footnotes now show an expense and increase in equity for the fair value of the options granted. It is difficult to understand how simply the recognition of an expense as opposed to its disclosure can somehow make it "prohibitively expensive".

If Time Warner had paid for advertising by issuing stock options would that advertising have been less expensive than if it had been paid for with cash?

Stock option accounting can create great discussions in class as students examine the issues surrounding the topic.

Change and International Financial Reporting Stds

2005-02-17T11:06:00.000-05:00

In 2005 International Financial Reporting Standards will be required in at least 65 countries for all of their domestic listed companies. Most importantly this includes companies in the 28 EU (Eurpean Union) and the EEA (European Economic Area). This change in reporting obviously may resuylt in some confusion and in difficulty comparing results from period to period. Take for example the following article concerning German Company Hochtief:

Hochtief AG, Germany's largest builder, said profit last year gained 17 percent, boosted by a change in accounting standards and by rising demand.

Pretax profit advanced to 187 million euros ($243.5 million) in 2004 from 159.5 million euros a year earlier, the Essen-based company said today in a statement.

The company gained from the International Financial Reporting Standards, which end the regular expensing of goodwill related to acquisitions.

One interesting piece in the article focuses on the question of whether the company's earnings really did improve as much as suggested:

Hochtief's earnings beat the 171.8 million-euro median estimate of six analysts surveyed by Bloomberg News.

The company wrote down 21.1 million euros of goodwill amortization in 2003. Pretax profit without this expense would have been 180.6 million euros instead of 159.5 million euros.

So without the expensing of goodwill earnings in the previous period would have been 180.6 euros and the improvement over the previous period would have been only 3.5% not 17%.

The changes that are occurring are just one more reason that it is important that accounting students be introduced to International Financial Reporting Standards.

SOX and errors

2005-02-16T10:10:00.000-05:00

Previously, I have mentioned the numerous accounting restatements related to leases in the restaurant industry (here is a recent letter by the SEC's Chief Accountant clarifying some of the issues). These restatements seem to have been brought on by the compliance requirements of SOX 404. Many in practice have suggested that SOX may not provide any benefit or that its cost outstrips its benefit (for a discussion of both sides, see this debate).

For an example of how SOX made an extreme difference for one company and its investors, take a look at Sirva and its recent press release providing earnings guidance. Sirva had been projecting earnings of $.15 - $.17 per share, but due to finding errors in its insurance and European dividsions as a result of SOX 404 it is now projecting losses of ($.16)-($.20) per share. Here is one of the relevant paragraphs from the release:

In the fourth quarter of 2004, the company commenced a thorough review of its accounting practices and significant balance sheet accounts, which has led to the identification of $21 million to $25 million pre-tax, or $0.18 to $0.22 per fully diluted share, of charges in its Insurance and European operations. The review was undertaken in connection with implementing procedures to comply with Section 404 of the Sarbanes-Oxley Act, the disappointing performance of the company’s Insurance and European businesses in the third quarter of 2004, and as part of its year-end closing process.

Co-Cos

2005-02-15T13:02:00.000-05:00

One item that has been creating a large number of restatements lately is "contingently convertible debentures" or Co-Cos. Co-Cos are a special type of convertible debt instrument that is convertible at the option of the holder into shares of common stock once the common stock trades above a certain price for a specified period of time (a market price trigger).

The Emerging Issues Task Force Issued "The Effect of Contingently Convertible Debt on Diluted Earnings per Share" ("EITF 04-08"). This new accounting rule requires companies with contingently convertible debt instruments to include the dilutive effect of the contingently convertible debt in diluted earnings per share calculations regardless of whether the market price trigger has been met. The rule requires retroactive application.

The rule basically requires that Co-Cos be treated like traditional convertible debt. One important question for students is why were Co-Cos created?

Actuant Corporation recently released a press release about its restatement of net income as a result of issuing contingently convertible debt, a small bit:

The impact of adopting the new accounting rule is a reduction in diluted earnings per share, but not net earnings. The quarterly restatement of diluted earnings per share for fiscal 2004 and 2005 is reported on the attachment to this press release. In calculating diluted earnings per share under the new rules, Actuant is required to add back the net of tax charges for interest expense and debt issuance cost amortization related to the 2% Co-Cos to net income (restated numerator) and increase the weighted average outstanding shares for the shares issuable under the 2% Co-Cos (restated denominator).

Taxes and losses

2005-02-10T16:48:00.000-05:00

We are discussing deferred taxes this week and a company that has a number of interesting issues is Amazon.com The company reported its 2004 results this week and interestingly it is starting to finally use its loss carryforwards from all of the losses it generated. I found it interesting that the Wall Street Journal termed the recognition of the tax carryforward a "gain" from tax benefits. Here is a cut from Amazon's press release:

Net income was $347 million in the fourth quarter, or $0.82 per diluted share, compared with net income of $73 million, or $0.17 per diluted share, in fourth quarter 2003. Pro forma net income in the fourth quarter was $394 million, or $0.93 per diluted share, compared with $125 million, or $0.29 per diluted share, in fourth quarter 2003. Excluding the benefit from realizing a $244 million deferred tax asset related primarily to net operating loss carryforwards attributable to continuing operations, fourth quarter pro forma net income would have been $149 million, or $0.35 per diluted share.

One interesting item that can be brought out in class with Amazon is that the company only reports a deferred tax asset of $81,388,000 at Dec. 31, 2004 even though the net operating loss carryforwards are much greater.

Inventory write-downs

2005-02-10T14:52:00.000-05:00

Normally when I talk about valuing inventory at its lower of cost or market (LCM) I state that one reason inventory can lose value is because of obsolscence or technological change, however my examples are usually not real world. However, today I saw a news release about Teletouch a company that operates a paging and two way messaging network. Cellphones and wireless networks are slowly making pagers obsolete and as this occurs we see companies in this area taking inventory write-downs. Here is a cut from the Teletouch's second quarter press release:

Teletouch recorded an operating loss of $457,000 for the latest quarter compared with operating income of $52,000 in the second quarter of fiscal 2004. The increased operating loss was primarily due to fewer pagers in service at the end of the period. The second quarter 2005 results include approximately $331,000 in inventory write-downs compared with $203,000 in the same quarter of last year. Adjusting for the inventory write-down, the Company would have recorded an operating loss of $126,000 for the quarter compared to an operating profit (net of inventory write-downs) of $255,000 in the comparative quarter last year.

More troubles with lease accounting

2005-02-08T12:46:00.000-05:00

Hypercom reported that it will need to restate its results for the first three quarters of 2004 to correct how it accounts for its leases. Previously it had concluded that 3,200 of its leases should be accounted for as sales-type leases when instead it should have accounted for the leases as operating leases. The company stated that it will lower its revenue by over $4 million dollars for the first three quarters, it also reported that operating revenue would be cut by $2.6 to $3.0 dollars. The gross margins on these leases must have been large (somewhere between 65% to 75%), and this suggests the reason why Hypercom would want to treat the leases as sales type leases.

An examination of this restatement also allows for a good class discussion of the motivations for lessors and lessees. Most lessors want capital lease treatment, while lessees would rather have operating lease treatment. Students should be able to think about why lessors and lessees want differing treatment and how through proper structuring each can get what it wants. usually this is done by purchasing residual value insurance or more complex structuring.

FAS No. 153

2005-02-05T14:03:00.000-05:00

The new FAS 153 changes the accounting rules for nonmonetary exchangesof assets. Previously, the accounting rule for "similar" assets was fairly close to the tax rule for Section 1031 exchanges. The new rule in FAS 153 refers to exchanges with "commercial substance" rather than on the similar/dissimilar distinction. A gain does not have to be recognized on those exchanges that are without commercial substance. This change in the rule was made in order to make the FASB Statement more consistent with the International standard (the so-called convergence). While it does make the rules more consistent with International standards, it makes them LESS consistent with tax rules. The result--an additional book-tax difference that may give rise to deferred tax calculations.
-Curt Norton

International Accounting Rules

2005-02-04T11:35:00.000-05:00

One of the many issues we address in our textbook is the role of international accounting standards and issues. In January the IASB reported that it and the Accounting Standards Board of Japan had agreed to take steps towards international convergence. This is one more imporatnt move towards an international set of standards. Given that almost all listed companies in the European Union must adopt and apply International Financial Reporting Standards to their consolidated financial statements beginning in 2005, it is important that accounting majors become familar with international issues. I will try to highlight more items as we go forward.

Repatriation of Foreign Income and deferred taxes

2005-02-03T09:06:00.000-05:00

One item affecting a number of company’s fourth quarter earnings releases is the tax effect of repatriating income held overseas by foreign subsidiaries. This provides an interesting discussion topic when covering deferred taxes. One provision in the big November 2004 tax bill (American Jobs Creation Act of 2004) was that companies could repatriate overseas profits at a rate of 5.25% (much lower than the normal 35%).

Previously the accounting for this item was based on what the company was expecting to do with the money.

If a company was not expecting to repatriate the foreign profits and instead stated that it would permanently reinvest the foreign earnings it was not required to recognize any U.S. taxes on the profits. Usually companies would disclose the amount of permanently reinvested foreign earnings in the tax footnote. For example in its 2003 annual report Kellogg’s discloses the following:

At December 27, 2003, foreign subsidiary earnings of approximately $1.09 billion were considered permanently reinvested in those businesses. Accordingly, U.S. income taxes have not been provided on those earnings.

Companies that have not provided for taxes on their foreign earnings will recognize a tax expense (and tax liability) in the period they elect to repatriate foreign earnings. The amount of the tax expense will be 5.25% of the amount repatriated. In addition, these companies will have much higher effective tax rates in the period of the election. For an example of this take a look at Johnson and Johnson’s fourth quarter earning release.

If a company has provided for U.S. taxes on its past foreign profits it set up a deferred tax liability (since the tax is not due until the actual profits are repatriated) equal to 35% of the foreign profits. If the company elects to repatriate the foreign income this period than it will result in a decrease in the deferred tax liability and an adjustment to the tax expense.

For an example of a company that had previously provided for U.S. taxes and is now able to get a benefit from the repatriation look at the earnings release of Autodesk.

Earnings Restatements

2005-02-02T14:38:00.000-05:00

Most days the Wall Street Journal reports a list of the companies that are restating earnings for whatever purpose. January 31, 2005 had ten companies restating earnings and these restatements realated to the following:

Software Revenue Recognition issues - three companies
Other revenue issues - one company
Contingently convertible debt - one company
SFAS No. 140 - one company
Variable interest issue - one company
miscellaneous error(s) - one company
Deferred tax liab. - one company
Leases - one company (Pep Boys)

All of these are intermediate issues and provide great examples for the classroom. Right now my class is covering leases so I used the restatement that pertained to Pep Boys as an example in class. The restatement relates to property leases in which PepBoys has made improvements. This issue affects many companies in the restaurant and retail industry and results in most companies recognizing more rent expense or depreciation.

For a good article on the subject see this story in CFO Magazine

The beginning

2005-02-02T10:23:00.000-05:00

I am starting this web blog to collect and share current thoughts and ideas about intermediate financial accounting, both issue oriented and teaching oriented. The web log will be updated as quickly as news about financial accounting comes about or a teaching idea comes into my head.

The site is used to support a new textbook written with Curt Norton and Mike Diamond with the title: Intermediate Accounting: Financial Reporting and Analysis. The first edition has just been released by Houghton Mifflin and you can learn more on our website.

I look forward to posting information related to accounting and teaching issues and hearing your feedback.

Don Pagach