Implications: Jane J. Thompson, called prepaid cards and money center services “foundational products” and ““Our concept is to go up the credit ladder of financial services,” The new products, like the prepaid debit card, will be offered through third-party partners, allowing Wal-Mart to sell bank like services without a government license, very important in view of the previous failures and current regulatory climate. .“The logic behind a lot of these services is to increase traffic and do it in a way that puts money in people’s hands,” said Andrew Dresner, a payments industry consultant at Oliver Wyman Financial Services. “You give them a couple hundred dollars,” when they cash their paycheck, “and they will buy other things.” Combine the logic of proximity with the fact that 20 percent of customers, 27 million people do not have checking accounts, and you have a truly potent combination.

Analysis:  

First I believe the failure to win approval for an industrial bank was fortuitous for a number of reasons:

-Asset driven industries are radically different from the revenue driven. The corporate cultures and view of risk make communication and coordination difficult: remember the Sears Dean Witter merger.

-Financial manipulation is more easily done when a company has a financing arm, especially in areas of revenue recognition and credit strength.

-Wal-Mart has a lot of political ’sail area’. The company is high profile as it is, and a bank attached to it would just give their enemies and other stick with which to beat them.

In this area, outsourcing is the key, and promises not to add distractions to its place as a retailer.

This move will tie the lower income customers more firmly to the company. As noted, they have many customers who have no checking account. Most, middle class people don’t understand the numbers, or mentality of this market.

It was not so long ago, that people would visit the local phone company and pay in cash, and perhaps pay other utilities at the supermarket (a new phenomenon) when they cashed a pay check. Other used a check cashing service or similar money service company to get cash, which is also expense, relatively.

The money center will offer a number of advantages over the older systems:

-They will be able to cash their checks and deposit the money in a money card, which will be accepted any place VISA is. Thus, money orders may become a thing of the past for some users.

-The price is lower than a bank. The initial card costs $8.95 with a $4.95 monthly maintenance fee. Cash can be put in for free when cashing a payroll check or direct deposit. Other wise, the reload fee is $4.64.

-The card offers greater theft security by removing cash from the equation and access to bank services to people who may have never been in one.

In a larger sense, just getting people in on payday, for sure, would be a huge boost to business. I am sure now, some families go to the Wal-Mart on payday, any way, and now there would be even greater incentive to a family night out there.

I think that Ms. Thompson’s growth estimates 30 to 40 percent over the next year, are quite reasonable, but I would like to know a bit more on what the base is seen to be. I also believe that they can improve their reach with some changes in the practices described:

-Lower the maintenance fee as far and as fast as possible, hopefully to zero. One of the reasons they don’t use banks is the expense. In my experience, they know to the penny what there check is going to be, and need all of it to get by. They literally do live from paycheck to paycheck.

-If fees are necessary, then see if it is possible to off-set them in part with purchases. A grey area, but like I say, costs are important.

-Consumer finance might better be approached by using a range of lenders not associated with the company. Such would cut down on the possibility of self-dealing or the perception of the same. It would mean that non-recourse debt would stay that way. Consumer finance is a well-developed business. Use that fact to advantage rather than building new.

In summary the result will be better than going into banking or consumer credit. In this way Wal-Mart can shape the new efforts to the core business rather than having taken on a life of their own.

Implications: PCAOB’s chairman Mark Olson has said of SFAS No.159: "The increased use of fair value accounting poses a challenge for auditors and the PCAOB." Time is short as this SFAS goes into effect for most companies for financial years beginning after November 15, 2007, except for early adopters. The new standards cover valuations of stocks, bonds, loans, warranty obligations, and interest rate hedges when the Fair Value option is elected. Under existing PCAOB standards, the auditors need to understand how such estimates are derived and may have to develop independent estimates when independent data is available. Both SFAS No.159, “The Fair Value Option for Financial Assets and Financial Liabilities” and No.157 “Fair Value Measurements”, are going to have a great impact on how financial information is presented and the additional testing, both factual and procedural to properly audit it.

Analysis:  

The whole concept of Fair Value discredited by Adam Smith, and has been considered to be functionally dead for centuries, under the name of just price. In a market place just compensation is based on a price consented to by both a buyer and a seller. Fear of ‘just price’ calculations are in the Constitution in the takings clause of the Fifth Amendment. The founders were very suspicious of takings and the use of just price to value them.

When a mutually negotiated price does not exist, you have a forced sale which in this case that the firm’s assets are worth what management says they are, not the market. As in any forced sale or taking, the valuation is based on proxies such as prices for “comparable” properties, which are often not identical. When there is a market, many things can be priced, but these two SFAS range from a market for fungibles, such as stocks or commodities, to estimates.

The subprime market shows the result of such manipulation. See this article: http://www.nypost.com/seven/06202007/business/subprime_street_is_feeling_the_heat_business_roddy_boyd.htm

“Carrington has raised eyebrows among rivals with its portfolio-valuation methods. The fund values its bonds based on the amount of principal and interest payments the bond is anticipated to make, while most funds use current trading levels.”

Here we have an example of how Fair Value can be misleading and non-transparent. As a note, Lehman and Credit Suisse have already auctioned off their share at 50 cents on the dollar, and Merrill traders would be happy if they can get that much. Carrington’s valuation, by their own methods is up while other similar funds are down.

Before going into some of the specifics, let’s engage in a bit of levity. A man walks in to a fruit store, and notes that bananas are $2.00 per lbs. He and the owner have the following exchange:

Customer: Nick’s price is $1.50 per lbs.

Owner: Well does he have any bananas, today?

Customer: No, he’s sold out.

Owner: Well, when I don’t have bananas, my price is $1.25.

As you can see, without offer and acceptance the very idea of a price becomes a joke.

Clearly the accounting profession is steadily distancing itself from the market and value based on freely consented transactions. It should be noted that a large part of the buyout business is based on revaluing assets for both book and tax purposes based on arms length transactions, rather than estimate. Assets values, in these deals, are more firmly based in reality for that reason. Heretofore, no one wanted to change asset value for any other reason because free exchange is the actual arbiter of value.

The first obvious and necessary change related to inventory values for anyone actively trading financial instruments: brokers and dealers. Marking to market has proved to be reliable and is subject to many limits related to concentration and marketability. More to the point the instruments are fungible and traded.

It would seem that the most visible change to estimates is based on compensatory stock options. The methodology is academically sound, but meaningless. First, the cost is non-cash and will not be monetized until sometime in the future. Less noticed, is that management can influence options value by making shares more volatile, and that can be accomplished by increasing leverage. The only good thing about the issue is that many companies are ending these plans: the true costs are hard to estimate, and shareholders are growing to dislike them, seeing stock options as dilutive and harmful to their investments.

There are difficulties however with this sort of application. In a 2006 academic commissioned be PCAOB. Jay Rich, a coauthor of the report stated: “No auditor can keep up with all this stuff. [The audit firms] need to have someone who specializes in valuation in place.” The tools used in SFAS No. 147 are finance oriented and are not nor would be expected to be part of the auditors training. Even with the emphasis on internal control checks, it would be doubtful that a person not trained in the field could design or assess controls over the process. Further, the auditors are not to attack these estimates even though time may prove them flawed during the audit.

In another CFO article, “The FAS 159 Mulligan” (http://www.cfo.com/article.cfm/9139916?f=related). Neri Bukspan, chief accountant at Standard & Poor's and a member of FASB's User Advisory Council felt that if it were used to hide losses or generate short-term gain it would be a problem. "If prudently used, [FAS 159] is beneficial," because it increases transparency, mitigates volatility, and gives investors a more realistic picture of the company. But in the wrong hands, it's a great concern, "It should be noted that the concerns were voiced in an article which raised concerns about an article directed at early adoption under paragraph 30.

I am surprised that a member of the User Advisory Council would argue that the statement increase transparency then provides a number of caveats. On the other hand, I have documented several of instances where I feel that user interests could be harmed by certain FASB/SEC actions, and worse that the proposals were blind to how financial information is used.

The substitution of Fair Value for market exchanges is a return to medieval thinking that most believe has been totally discredited by Adam Smith and two centuries of hard experience. If anything, this new format decreases transparency. The user does not care about intermediate values, but rather at what price the asset or liability may be liquidated for cash. Further, it is their responsibility to make that judgment and not accountants who lack the training to do so in the necessary way.

The only conclusion that can be drawn is that the accounting profession embodied by the FASB and the SEC is into matters of which they have no understanding, in ways that are either a waste of user time, or worse obscure critical information.

Implications: This article is based on “Control Overrides in Financial Statement Fraud” by Robert Tillman and Michael Indergaard of St. John’s University, available at http://www.theifp.org/research%20grants/tillman_final_report.pdf The study examines 834 companies that filed financial restatements between 1997 and 2002. Of those 374 (45 percent) were accused of securities fraud and subject to shareholder suits, SEC enforcement action or both. Of those resulting in legal action seven individuals on average were implicated holding a variety of senior positions, including board members. management and auditors  

Analysis: Methods

The study is worth reading because it shows the mass of information available, and point to many research opportunities that are ignored or mentioned and not explored.

The original paper is 94 pages long, and has other information of interest. With the information available it could have done more than address the state aim of: “…understanding how senior executives were able to commit financial statement fraud despite the presence of numerous control agents who, in theory, should have been able to detect and prevent those fraudulent activities.” (p38).

The first step was creating a Large-N drawn from 1997-2002 for companies from a

GAO sample of firms filing restatements consisted of 919 restatements announced by 845 companies. The GAO study “focused on financial restatements resulting from accounting irregularities but excluded those required by changed GAAP, organization or Class action suits filed against those firms with restatements. The sample was further broken down by and reduced by these data points:

-SEC action against those firms - 166

-Companies with class action suits - 348

-Companies with either/or - 374

There are problems with sample selection that should have been addressed and weren’t:

-Restatements are not a necessary indicator of fraud. Further there can be fraud when no restatement takes place that is the amounts were not material. As a note, materiality, at the time was generally held to be 5% of income.

-The sample was further limited to those firms with restatements that suffered class action suits, and SEC action.

The problem is limited the sample based on other people’s, in this case GAO’s, on initial sample selection. The description could have been clearer based on the following:

-Are restatements limited to amended filings or do they include restatements of prior year statements. The distinction is important because it ties to severity of the problems.

-Are the restated items cash or non-cash. This distinction is more important now than before. Non-cash items are less interesting than cash ones for the market and analysts.

-If restatements trigger class-action suits and SEC investigations, what about those that happened when there was no restatements? It would have been useful to look at other instances of legal action that were not associated with filing changes.

In summary, limited a study of fraud to items deemed by a third party to be fraudulent, is very limiting. Why not look at the universe, and then look at other indica besides financial restatements. 42% of the companies had class action suits and 20% had SEC actions. A better method would have been to start with the original group, and check that statistically, or problems.

For the Small-N sample, the authors chose 17 firms from the 166 subject to SEC investigation, which varied greatly in size. For this small group, the authors reviewed SEC documents and class action suit with an emphasis on individual and group relationships.

A better plan might have been to ignore restatements entirely and selected a Small-N from all suits or all SEC actions. By going from restatements to SEC suits, they ignored instances where there was wrong doing which had not been monetized as of yet.

Results

Everyone ‘knows’ that big frauds have a lot of people involved. This study actually puts numbers to the people and positions in the Large-N part of the study. In the 374 class action suits, there were 865 defendants and for the 166 SEC actions, and 2, 281 for the 348 class actions: five and six per case respectively.

New Economy firms comprised 38% of all the firms in the Fraud Sample and only 27% of the firms in the Non-Fraud Sample. In this case New Economy includes not only computers, but energy and telecommunications. The authors do not note that the latter two had undergone radical deregulation and speculative pressures at that time. The main finding was that the largest losses related to New Economy companies.

The important findings relate to the number of people involved and their relationship. Not only were the companies involved, but other companies, banks (actually broker dealers) law and accounting firms, made the cut. In the sample accounting firms were named 71 times, and when they were named the losses were bigger, mirabile dictu!

As noted, it was corporate finance departments named were involved in IPOs and accounted for the largest group of outsiders named: again no particular surprise.

Among company personnel, well the issue came right back to “Tone at the Top.” CEOs were in the box 89.7% of the time with CFOs covering at 78.3%. Board members were a distant third at 40%. Thus, as we might expect, fraud is done by those with power and opportunity.

In the Small-N sample the authors explored the relational dynamics of fraud. Executives at both the middle and senior management levels had the ability to override controls even when acting alone. More noteworthy was the fact that they rarely were alone: in 12 of 17 instances, CEO colluded with others. Further, clusters of senior managers actually normalized corruption.

In the Small-N Sample, found three types of fraud:

-Isolated frauds had six cases, with only one CEO involved and no CFOs. These show how senior management can act alone by restricting information.

-Frauds by senior management cliques with three of the six total combining to manipulate financial results.

-Boundary crossing frauds were similar to cliques, except that they involved recruiting lower level managers.

As for auditors, whether there was collusion or not, in ten or the seventeen cases, no resistance was offered. Oddly enough, Sarbanes-Oxley puts great weight on senior management attestation of results, but it must be noted that auditors run a much greater reputation risk than management but seems to have no problem being involved with fraudulent results.

I think this paper is of interest because it shows the levels of collusion in frauds over a number of years. There are some weaknesses and areas where further exploration is necessary:

-There is a big difference between a fraud that takes company assets and one that misrepresents company worth. This paper notes the difference but doesn’t show how the two are different.

-The sample is skewed because it starts with restatements, then to a subset including suits and SEC actions. Most theft frauds are so small that the losses are not material. One large enough to be so, is quite uncommon or the company very small.

The study does provide some useful information, but I believe the sample selection was flawed and it did not exam enough individual companies nor discuss enough of the specific techniques used.

Implications: Kenneth Wilcox, President of SVB Financial, believes that Sarbox has made the US economy less competitive. He disputes claims by a Big Four accounting firms that the costs are declining, with second year costs only 40% of the first year. In 2006 SVB paid over $20 million to the Big Four, for an average of about $17,000 per employee. This is more than five times as much as we paid them only three years ago. The new rules have contributed to a shortage of trained personnel while PCAOB under SEC guidance discourages the auditors from either offering advice or exercising judgment. As a result, almost 10% of all publicly traded companies announced restatements in 2006. SARBOX has greatly increased the cost of doing business, and in the author’s view to no good purpose.

Analysis:  

It is easy to sympathize with Mr. Wilcox, and his personal experiences probably reflect the universal, to a greater or lesser degree. Unfortunately, people like Senator Sarbanes, feel that such arguments are mere empty carping. Let’s explore better arguments which attack the flaws of the law, rather than its results.

First, the law itself was debated and passed without the facts that came to light during the trials of WorldCom, Enron and Arthur Andersen personnel. Mr. Oxley has admitted as much and stated the Section 404, was much too intrusive, in retrospect, as embodied by PCAOB. What we are seeing is the use, of the Precautionary Principle: see http://dieoff.org/page31.htm

“Social planning in the economy, in technology, in morality and in social initiatives all can be justified by a loose and open ended interpretation of precaution. “

Part of the construct is:

“…a willingness to take action in advance of scientific proof of evidence of the need for the proposed action on the grounds that further delay will prove ultimately most costly to society and nature, and, in the longer term, selfish and unfair to future generations.”

By Mr. Oxley’s own admission, the above reasoning was used as the basis of what proved to be too precipitous action. The Precautionary Principle is used mainly in environmental regulation or drug approval, and is not applicable to the economy because the true costs are available or should be and are calculable. Thus the intellectual basis for at least a portion or the law is suspect. It should be noted too, that such laws restrict possible future benefits which can be lost, unnoticed: medicines, products, innovative management because the rules place barriers to entry, so many potential but unquantifiable goods are lost.

Along with Sarbox, have come a large number of rules from the FASB, which have resulted in a great increase in the number of restatements. Mr. Walsh writes:

“When I ask about the causes of [restatements], I am told the following: Neither companies nor can auditors really understand all of the primary accounting pronouncements coming out of the FASB, the number of which has gone from 104 in 1989 to 159 today. Many of them are 50 pages or more in length with accompanying interpretations that may be 10 times as long as the pronouncement itself.”

In my experience, the restatements center on stock options, SFAS No. 109 (Taxes) and derivatives. These restatements are non-cash, being changes in estimates or contingencies, and are thus of little interest to the analyst. Note that Navistar has done well after being delisted by the NYSE for failure to file financial statements. Dell has not been excessively punished for the same problem. In short, financial statements are not the final word for the investor.

One issue Mr. Walsh does not mention is auditor performance on general disclosures. Early in the profession’s history, the policy was that audited statements should have clear judiciously limited disclosures. That is, just putting in a trial balance or the whole chart of accounts with values, was not GAAP. At that time, the financial statement users were more limited and more sophisticated. The profession was also trying to establish its value by providing a useful service to people with a vital interest in the company, through junior and senior instruments or credit relations.

Now in the wake of Sarbox, no one wants to take responsibility for clarity or usefulness of the financial statements. In many instances the sheer volume of information render the useful data both hard to find and difficult to use. This practice can allow companies to issue statements that are deliberately or innocently misleading. More disclosure does not increase transparency.

The SEC and the FASB pay lip-service to representing the interests of the user, but there is little evidence to support this view. Both are in the process of capitalizing forward executory contracts and various contingencies placing them on the balance sheet. The debate over capitalizing operating leases shows a woefully limited sense of how the information is used or even the economic relations involved. In other cases, solutions with strong minority support would render some types of disclosures useless such as Statements of Cash Flows.

Supporters of Sarbox point to fact that there has not been a dramatic flight of US firms abroad. These arguments are wrong-headed for a number of reasons:

-Companies moving would or choosing to start elsewhere are small and would not affect the total.

-Capital markets are foot-loose, and there is little to prevent the movement off-shore, once the US environment is shown to be too burdensome.

-It is the new companies that provide opportunity, even if they are small, they collectively are the future.

-Some companies support Sarbox, which is an effective barrier to competitive entry.

-We may never know the true cost of Sarbox, because it will close possibilities aborning, which we will never now existed.

This article like so many others fails because it discusses compliance cost, which is easily rebutted by saying the regulation is necessary. As can be seen above, users don’t need the information, and Sarbox destroys the opportunity for new companies to enter the market. It was drafted using false premises (the Precautionary Principle), based on incomplete information relating to the events (WorldCom and Enron) in question.

Implications: Ms. Orit Gadiesh, Chairman, and Mr. MacArthur, Director of The Global Private Equity Practice at Bain & Company, believe that private equity is becoming a benchmark of performance for CEOs and boards of directors. The authors offer the following reasons for the popularity of private equity funds: -Funds focus on a reasonable time frame, three to five years typically, rather than on quarterly performance, the common timeframe for public companies. -Funds have detailed plans and time tables, enforcing discipline for clearly understood goals. -Funds quickly dispose of poorly performing assets, unlike some traditional managements. -Funds have a record of success, and exceptional earnings. Though not the only model, private equity funds provide an example of clear planning and solid execution with high returns from 1969-2006.

Analysis:  

Private equity funds have been around for a long time and have a solid track record for doing very well with certain companies and situations. Traditionally, their targets were troubled corporations that needed the hard financial discipline a highly leveraged capital structure requires.

Now there is much more interest, with traditionally organized new funds but also, new sources of funding for them, such as GS TRuE -- short for Goldman Sachs Tradable Unregistered Equity. This market will only be open to large institutional investors with assets of more than $100 million and will be neither registered with or subject to SEC regulation. NASDAQ and others are planning similar markets.

There are a broad list of evils which going private will correct to some degree.

-There will be less concern with making or meeting quarterly earnings estimates, which is time consuming, risky in a sense, and is pandering to fund managers who are just gaming the system, rather seeking true opportunities.

-As mentioned above, private management can plan and execute those plans over a reasonable period of time. Public Utilities have been willing to make significant regulatory concession to have, say, five years with no rate cases.

-Private funds get to choose there ground and have considerable experience with a range of companies. If you need surgery would you rather go to a hospital with a big practice in the area or a smaller one?

-Private funds are owner/managers so you do not have the agency costs associated with traditional management. There are no stock options, which are a sucker bet for stakeholders: heads I win, tails, we flip again, says management.

-Private funds can streamline internal systems and practices, needing only enough information to manage, rather than to satisfy the SEC. Current SEC disclosures, based on my experience as a Naval Intelligence Officer, resemble nothing so much as Soviet dezinformatsia, in both volume and clarity.

-Private equity funds must value all assets of the acquired company, to determine new GAAP and tax bases, which forces all concerned to look very closely at the ascribed values, and decide on which areas to emphasis and which to curtail or drop.

All the above have been present for decades in these deals, but now they are generally more attractive.

-SEC mandated disclosures, are seen as being less useful to investors. Navistar actually went up in value and has continued to do so despite being delisted by the NYSE, for failure to file financial statements in February 2007. It is now on the pink sheets and the market seems satisfied with periodic report of shipments and the status of the required multi-year restatements. Share price has gone from under $50, when it was delisted to $63 on May 30, 2007.

-Sarbanes Oxley compliance is quite expensive, and many have complained that these reports help neither the company function nor protect investors. In many instances, the control weakness relate to reporting issues that do not provide useful information to investors, or management.

-Sarbanes Oxley compliance can result in companies with a decentralized or holding company structure being priced out of their niche by these requirements. AES Corp. might be an example of such a company. It has over 700 subsidiaries, and has control weakness in the SFAS No. 109 area (taxes) and hedging, none of which has the slightest thing to do with whether it is a solid investment or not.

Again, Sarbanes-Oxley is one of the salient forces in the move from the SEC regulated markets. It should be noted that if it were radically changed, as Mr. Oxley suggests, the trend would still exist to leave regulated environments. Not only are the requirement expensive, even without all the onerous parts of this act, but many are coming to feel that the obsession with quarterly earnings, and the agency costs of current management are simply not the most effective method of wealth creation.

In the article, the authors mention that British supermarket chain J Sainsbury turned down repeated offers from a group including, Blackstone, TPG and Kohlberg Kravis Roberts & Co. because it felt management could solve its own problems without taking on the massive debt involved in going private. The critical question is if they can do it and know what has to be done, why haven’t they done it already? I would suggest that management is much too comfortable, with their current situation. I am reminded of the ancient Persian folk character Nasruddin. He promised the Shah that he could teach a donkey to talk in three years. A friend asked him what might happen, and Nasruddin said: “I could die, the Shah could die, or the donkey could learn to talk on his own.”

Sarbanes-Oxley is the villain of the piece. The law was written before all the facts related to Enron, WorldCom and the other scandals were known through the public record. Mr. Oxley has admitted that the law went much too far, especially Section 404 which establish the PCAOB. What has happened in an exercise in the Precautionary Principle, which in the name of preventing problems ignores the costs of doing so.

As a result, companies not only have unnecessary expense, but decentralized organizations are simply not feasible with the rules in question. These rules further serve as barrier to entry, requiring expenditures which might better be spent on the core business. The world will never know the cost because what might have been, will never exist: a silent witness as Cicero was first to note..

In summary, this article shows how flexible the world capital market is, and how bad law is defeated by it. Investors will simply not pay for what they don’t need, seeing information as just another good, and in the case, it will not be supplied, no matter the law. No matter, Sarbanes-Oxley has wounded the US capital market, and the corrections, it will not be the same again.

Implications: In the months to come, the FASB and the IASB, its European counterpart, will release a draft on plans to revamp current financial statement disclosures. Two possible changes cited in the article are the disappearance of net income, and an asset presentation that no longer separates assets and liabilities. The following link provides possible financial statements under the proposed rules:http://online.wsj.com/public/resources/documents/WSJ0507-fasac_march07.pdfIn the past, financial statements were issued to satisfy the needs of bank lenders. One of the goals is to provide investors with better information. It is envisioned that one day, a global set of accounting standards will come from this effort.Certainly, if implemented, the accounting disclosures would change radically, making the current professional knowledge base obsolete. The question should be: will these changes help the users?

Analysis:  

The absolutely bottom truth is that the accounting profession has absolutely no respect or understanding for the financial statement user. User objections to the change in income measurement came quickly:

Analysts in the London office of UBS AG recently published a report arguing this very point -- that even if net income is a "simplistic measure," that doesn't mean it isn't a valid "starting point in valuation" and that "its widespread use is justification enough for its retention

What they were criticizing was the change form using et income to showing comprehensive income. The following definition is taken from Statement of Financial Accounting Concepts No. 6, Elements of Financial Statements, December 1985:

70. Comprehensive income is the change in equity of a business enterprise during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners.

The argument for abandoning net income, as shown in the following quote is totally and absolutely specious:

“But giving that much power to one number has long been a recipe for fraud and stock-market excesses. Many major accounting scandals earlier this decade centered on manipulation of net income. The stock-market bubble of the 1990s was largely based on investors' assumption that net profit for stocks would grow rapidly for years to come.”

First of course, no knowledgeable user places faith in only one number, but will use a variety of measures to develop and understanding of the company. Further, comprehensive income is derived in the same way, but does not require any analysis on the auditors part. Any income manipulation would be done in exactly the same way, by misstating assets

The key issue is that net income relates to operations and comprehensive income includes all items now shown as change to comprehensive income, such as some hedging activities and marked-to-market assets. Ideally net income would exclude all non-recurring items, while in practice, the users have to adjust for themselves based on specific enquiry or disclosure. FirstCall has developed a business supplying this analyst information to the buy-side.

The rationalization offered by Robert Herz, as quoted in the article is a follows:

The goal of the accounting-rule makers is to better reflect how businesses are actually run and divert attention from the one number. "I know the world likes single bottom-line numbers and all of that, but complicated businesses are hard to translate into just one number,"

The reasoning is specious as analysts use many more measures than net income, to make judgments of performance and value. Further, the FASB has emphasized comprehensive income and ignored issue related to the income statement per the source quoted above. Using only comprehensive income can be seen as easy the auditors work, and cutting exposure.

Now let s see if the proposed disclosures actually are more useful than current practice:

-The most obvious difference in the presentation is that positive and negative numbers are inconsistently applied. On the income statement, credits are positive and debits are negative. On the balance sheet, debits (assets) are positive and credits (liabilities) are negative. This change in itself will make user data collection and analysis more difficult and flies in the face of practices used in the books of original entry.

-The claims the comparison are but straw men: income statement and balance sheets are currently more detail than shown, when necessary. The proposed breakdown is longer but not necessarily more useful. Cost of goods sold is poorly presented with unnecessary detail on depreciation show, with no indication of amounts inventoried or not.

-SG&A begs the point. The question what are controllable fixed costs and what are variable. There is no indication that that sort of information will be provided.

-Analysts would, based on transaction substance, remove items in other comprehensive from the analysis. These items and others such as gains from asset sales can be easily be manipulated by management, to meet whatever will pass as earnings in the future.

-Lumping assets and liability is egregious and makes analysis more difficult. The current system allows a quicker less formal matching. The new require extensive manipulation. Current versus long term is arbitrary, but provides a better basis for matching assets and the claims on them.

-Cash flow is a reversion to the direct method, first proposed in SFAS No. 13, and roundly rejected by industry and the analytical community. There is no visible evidence that anyone wants to revisit that issue other than the FASB.

The proposed changes simply do not satisfy user needs any better than before and will be, perhaps worse. Rather than asking what the user might want to know, they have decided, ex cathedra to place dogma over need.

What would an analyst like? Here are some examples:

-In formation by lines of business containing more detail than currently, in some instances stand alone financials.

-No consolidation of asset and revenue driven entities, even financing subsidiaries unless complete subsidiary financials are offered too.

-Present revenues from specialized contracts existing outside the normal sales cycle.

-Capital expenditures shown by type: existing plant, plant expansion, acquisition.

-Information on units sold, produced and in inventory.

In summary, these proposed changes in disclosure a best offer to decrease potential errors and exposure by moving away from net income measure. Further the disclosures themselves bear no resemblance to what management uses or what analysts would like to see. I await rebuttal evidence with anticipation.

Implications: “101 Mission Statements form Top Companies” by Jeffry Abrahams is the author’s on the great modern creation, the Mission Statement.The book itself has only eleven pages of original writing, then all collection of mission statements. The ones mentioned in the review, have little if any connection with what a company is actually doing. Gillette’s mentioned nothing of shaving, “. Perhaps a mistake: Today Gillette is a part of Procter & Gamble.”The whole issue turns on providing a clear statement which can usefully guide the people in a company. It is basic and simply, but a thing people can refer to when making decisions for which there is no other guidance. J&J’s served it well during the Tylenol recall. Would others do as well?The implications go beyond mission statements to quality of thought going into planning and strategy,.

Analysis:  

The Mission Statement is best place to start in any company analysis. It is the one place where a link is stated, even implicitly of the company’s relationship to the world at large. Tracking the management’s thinking from the mission statement, to business plan to organization to final execution can provide a solid risk profile, especially those associated with management performance. This logical step can filter a lot of noise and show flaws that are both cheap and easy to fix, making for profitable opportunities.

The Red Army (Soviet) plans differently and perhaps better than the US, which starts with capability and builds toward a goal. The Soviets defined the goal then developed plans to get the assets needed to achieve it. Older authority argues that one should count the cost of a house before the building begins, lest an unfinished dwelling make a person look foolish.

Once a real or implicit mission statement is in hand the next step is to see if it bears any relation with a company’s assets or forward plans. If the plans change with the season, or are logically inconsistent with the mission statement there is a problem, and no excuses serve. If top management say they are in transition and too busy, they are too busy to manage the company because you cannot effectively manage without one.

Problems can relate to the ‘how’ of the business. If management claims to be decentralized and employee driven, a check of the incentive compensation plans is in order. If options or other incentives are essentially limited to the CEO and those close to the throne, questions of candor and ability immediately come to mind. In such circumstances a review of the plans may be in order. Transaction oriented companies, say pharmaceutical shops that buy rather than develop will have to have a much richer plan than a continuous cost manufacturer, and that will not be a red flag per se.

Many companies have bad internal control reports, but some problems really relate to diversification or structure and are not as important. Internal controls ensure that assets and liabilities shown in the financial statements exist, the company has the legal rights therewith associated, and that the financial statement are complete, properly valued, and presented according to GAAP. Proper financial reporting may be totally irrelevant to company performance.

A holding company’s subsidiaries could run without GAAP reporting at all, because the operating controls would provide sufficient information to satisfy everyone involve. Dell Computer has not issued any financial statements for a while, and the price hasn’t tanked. There is too much confirmatory information available to have that happen. It must also be noted that many restatements are not related to asset existence or valuation, but rather, non-cash items related to accounting estimates and not value. SFAS No. 109 Accounting for Income Taxes, is a prime example especially when combined with FIN 48: the information is irrelevant to either management or analysis.

This process is an integrity check on management to see if their words actually match structure and resources available. The goal is to strain out the superfluous and confusing data managements offer in the name transparency. Any company must be able to tell what it is planning to do with shareholders’ money in the further in order to make them richer. Let’s say two companies, in a growing industry, have $100MM. One wants develops a forward plan that uses the money to invest in capacity, and the other plans to hold the money in T-Bills. Which looks better? In some instances the second might be better, but that decision should be based on the quality of thought and reasoning.

Examining the mission statement, structure and plans can be an excellent way to quickly gain an understanding of a company and its worth. It provides a way to develop and organized understanding of a company when the disclosures offered in the name of transparency are overly long and opaque. If a company has a bad story and mediocre management, those problems can be corrected quickly and profitably.

Implications: On April 26, 2007 Kohlberg Kravis Roberts & Co. and Goldman Sachs Group agreed to buy Harman International for $7.8 billion in cash: $120 a share, a 17% premium. The wrinkle is that shareholders would be allowed to exchange their holding for shares in the new privately owned company. There have been other instances such as Kindercare, but ordinarily they don’t build them into the original offer. These so-called stubs would be traded OTC if at all, and would be subject to reduced regulation. Stub equity allows a buyout firm to put more of its own money to work on a deal, by reducing the amount of capital it needs to raise from other buyout funds, and the need for other partners. The concept is interesting, but it says a great deal about other issues as well.

Analysis:  

This change actually represents more than the articles describe. The received wisdom has always been to take the cash in preference to financial instruments. This practice has been repeated confirmed in the best thinking, notably Bennett Stewart and others. The question is why the change now?

The proximate cause relates to the Clear Channel Communications where the owners claimed that the deal was underpriced at $18.6 billion, and forced a better offer. In a similar case, at Lear Corp., the buyers refused to budge. The increased complexity might make it easier to get the deal done. As a note, the stock opened on May 1, 2007 at 121.47, which means that the owners see the initial offer as only a start.

Stub equity has a number of advantages for the firms. It allows the buyer to use less of its own and its partners’ money on each deal, and cuts the size of bridge loans to back the larger transactions which are both expensive and risky. It allows for doing more deals, which cuts portfolio risk, without the additional complexity or more partners.

The hope is that the use of stub equity might discourage a counter offer by encouraging the owners to cast their lot with KKR and Goldman. The net effect is that the voluntary acceptance of stub equity would give the partners 73 % of the deal and while only having to pay $2.7 billion of the total price of $7.8 billion.

The next issue is perhaps the most important: are stakeholders will to jettisoning oversight be it from a public board. This issue is much more important than it sounds.

Most boards follow the guidance enough for the appearance of independence in accordance with guidance from Sarbanes-Oxley and other monitors. However, further investigations show fundamental flaws. Many boards benefit from stock option programs. Some have audit committees have ‘financial experts’ who have no experience with the high-risk areas of the business. Other audit committees have empty suits like Judge Webster who bring discredit on the process. For these reasons, and others, many investors see boards of directors as irrelevant show.

As to management, the more knowledge investors see the absolute difference in interest regarding management caused by stock options. Shareholders take risks. Management holders of stock options do not. In many cases their risk profile is skewed because they only have zero to positive profit potential. Too, management is motivated to increase volatility through increasing leverage or merely by manipulating news.

Sarbanes-Oxley compliance is very costly and it is not clear that it has any market value at all. Dell hasn’t issued financials in a while, and its stock has not crashed. GM has a number of control weaknesses and restatements, and is being judged by it fulfilling its recovery plans. A company, especially one with a lot of buckets, can function well while not fulfilling the minutiae of internal control formalities. In deed, for many companies that are highly decentralized or are true holding companies, full implementation of Section 404 might destroy their competitive advantage, and actually increase risk for shareholders.

There are solid inherent advantages to taking a stub in such deals. These major buyout firms have a solid track record of doing these deals. If you get sick, you go to the hospital that handles the most of what you happen to have. The funds have seen and done everything so have a real fund of experience to draw on, and are not restricted to a single industry. Better yet, the stub holders and the others owners have the same interest: maximum going public price. More to the point, the funds have a plan, with a timetable. Many managements, despite a lot of words, really don’t have one, especially one where progress can be measured against a time table.

Self-dealing has been mentioned as a problem, and that can be. Certainly the funds will be somewhat constrained by the stub holders. In this particular case, the founder, Sidney Harman is going to go half cash and half stub. Though the deal specifics are not yet set, it is likely that Mr. Harman will protect himself and the other stub holders from misfeasance by the fund. I also suspect that this deal might result in a model agreement for such buyouts.

Will the deal fly? Well there are still some unresolved issues, especially on what management fees the stub hold will permit the fund. These sorts of minority interest or debt related issues can be tough, but nothing that has not been done before. What actually happened at Kindercare say is not known

In later news, Goldman Sachs announced a new system, GS TRuE -- short for Goldman Sachs Tradable Unregistered Equity -- two weeks ago and made its debut on Monday, May 24, 2007 with an $880 million sale of a 15% stake in Oaktree Capital Management LLC, an alternative-investment manager. This market will only be open to large institutional investors with assets of more than $100 million.

It is the first of several new, private exchanges like these being considered by Wall Street firms and others. Nasdaq is also planning its own new market for smaller, unregistered securities, not registered with the Securities and Exchange Commission nor subject to its designed to protect the individual investor. See the following WSJ article for details: http://online.wsj.com/article/SB117996989061312894-search.html?KEYWORDS=goldman&COLLECTION=wsjie/6month

What is clear is that the market is not impressed with the protections embodied in Sarbanes-Oxley as elaborated in Section 404. More such deals will show that the market does not value the offered protections.

Implications:  

The Sarbanes-Oxley Act of 2002 passed all most unanimously and received a grudging acceptance from corporate America. This article contains and interview with Mr. Oxley.

Section 404 of the Act and the rules promulgated by the Public Company Accounting Oversight Board (PCAOB) a private-sector, non-profit corporation created to oversee the public company auditors.. Its stated purpose is to 'protect the interests of investors and further the public interest in the preparation of informative, fair, and independent audit reports'.

The results tied to Section 404, especially relating to the PCAOB have been very strong. Mr. Oxley, himself, has come to view the actual implementation of this section as flawed. He believes that: “It was Auditing Standard No. 2 [the standard for auditing internal controls over financial reporting], promulgated by the PCAOB that started all the problems…. but by the time the PCAOB was done, it was 330 pages of regulations. It was far too prescriptive and [more] expensive than anyone anticipated.”

Thus we have a section of the Act, which has grown to the level that one of the authors sees problems with it. The following link gives good, general help:

http://en.wikipedia.org/wiki/Sarbanes-Oxley_Act

Analysis:

I believe that PCAOB using Auditing Standard No. 2 is case of the inappropriate use of the precautionary principle, in the following way:

“Preventive anticipation: a willingness to take action in advance of scientific proof of evidence of the need for the proposed action on the grounds that further delay will prove ultimately most costly to society and nature, and, in the longer term, selfish and unfair to future generations.”

“The precautionary principle evolved out of the German socio-legal tradition, created in the heyday of democratic socialism in the 1930s, centering on the concept of good household management.”

Earthscan Publications http://dieoff.org/page31.htm

The precautionary principle is with us today in the Global Warming agenda, which really recognizes no connection of cost to benefit. The excess and onerous rule making by the PCAOB seems to be symptomatic of this mind set, which has, an interesting pedigree and of the same place and time as the eugenics movement.

Mr. Oxley: “Now is the time to revise it and wring out costs. This is how the system works. We had the foresight to put in the kind of flexibility in [Sarbox] that allowed the SEC to defer smaller companies to comply….it is important to weigh the costs with the benefits. As the PCAOB gets us back on track in terms of the benefits versus the costs, they will protect the investor and make it more cost-effective.”

Thus we have that cost benefit analysis related to risk had not entered into the original legislation, but that seems to be a hoped for change. Whether suits to end PCAOB will work in the long run, is another issue, or whether proposed reform will do the necessary heavy lifting.

One concern is the politicization of the FASB with the SEC taking a strong role in GAAP formulation. As I have stated many times, the FASB has talked of protecting the interests of the financial statement user, then uses no apparent input from them before setting the rules. In fact, some rules make analysis more difficult in many areas, such as SPEs, Cash Flow Statements and leasing.

The costs are high and have been so for a while. Robert Posen chairman of MFS Investment Management decried the expense caused by restatement in an article published in The Wall Street Journal on March 23, 2007. He is writing as a user, and sees no purpose to these regulatory mandated actions. In other cases such as Dell, some analysts believe that correcting the control problems there might cause a great increase in costs for the company.

Now that cost benefit analysis is on the table, let’s put this question another way. Every CFO knows how much the regulatory burden costs. Now we might ask, what benefit do these regulations have on share value? Obviously the information is anecdotal, but let take a look at instances of qualified internal control ratings:

-Dell has missed a number of SEC filings and will be late for the annual. What is the impact of shareholder value? Well it trades at about $24.00 now, down from a high in the low 40’s at the end of 2005. On the other hand, the $40.00 level was a spike when viewed over the last five years. More illustrative the company has not even tried to offer any progress reports. Seems the market doesn’t think the information very valuable.

-GM has greater problems and a lot of control weaknesses in the last 10-K. The sky did not fall. Analysts are watching the progress of the company’s recovery plans so these items didn’t have much impact.

It would seem that Sarbox is not terrible relevant to shareholder perceptions. The question then is why. As discussed earlier, the impetus was WorldCom, which is very much a special case. Telecommunications was undergoing major deregulation, with the whole market up for grabs, and little critical thought directed at what the total market might be, on the analyst side. Further, a look at WorldCom, shows that it was not internal control weaknesses that caused the problems. The controls were there, but management at one level or another worked to frustrate them.

Mr. Oxley noted that WorldCom was why the Senate added Section 404 to the bill. When Mr. Oxley asked if WorldCom speeded the process, he said: “The answer is yes, in retrospect. If we had more time, we could have proposed a laddering of applications. That's hindsight. At the same time, the key was the flexibility it gave regulators.”

I suspicion that the process went something like this:

-WorldCom is so big, that we can’t allow anything like this to happen again, no matter what.

-Bernie did the “Doofus Shuffle”.

-The law makers believed what they saw, saying that our pal Bernie couldn’t have done such a thing.

-If we mandate strong internal controls, no matter the cost, people like Bernie will not lose control to thieving subordinates.

Needless to say this thinking did not survive Bernie’s and trials of WorldCom employees.

It seems that SAS No. 99 and other older auditing guidance are more than sufficient to address the problems in question. It seems that PCAOB is now a post-retirement option for retired audit firm partners, and that the value that their efforts have added to financial disclosures for the analyst is nil, or perhaps less.

Implications:  

Dell Inc. announced that its 10-K, due April 3, 2007 extended to April 18, would not be filed on time. Dell has also failed to meet NASDAQ requirements for continued listing as a result of its delinquent periodic report filings.

This delay was based on evidence of unspecified misconduct, and has involved prior quarters as well. In August 2006, the Dell announced that it was under informal investigation by the SEC on revenue recognition.

The resolution of these issues, have been long in coming, and still it is not clear how high in the organization the issues reach, though there have been firings, but also in what they entail.

Even with all the delays, there is really no clear picture of what has gone wrong.

Analysis:

There are two issues in the Dell story. First the problems have hung on for a long time, and further, it is not clear exactly what is wrong, or how high the problems go. Of greater interest the market has not reacted strongly to this news, nor has NASDAQ. If internal control and accurate financial statements necessary to the market, why hasn’t the stock foundered given the circumstances?

As to the first part of the question, the best place to start is with a review of SAS (Statement of Auditing Standards) No. 31 Evidential Matterwhich define the assertions made in the financial statements. These assertions cover everything in the financial statements and how Dell might be deficient.

The first is existence: "Assertions about existence or occurrence deal with whether assets or liabilities of the entity exist at a given date and whether recorded transactions have occurred during a given period." Revenue recognition is part of this one because it turns on the existence of receivables. That in turn relates to passage of ownership. SAS No. 99 because of the prevalence of revenue recognition issues in cases of fraud, requires specific tests on revenue with the objective of identifying indications of material misstatements due to fraudulent financial reporting.

Completeness deals with whether all transactions and accounts that should be presented in the financial statements are so included. It would seem that assertion is not an issue. If it were, we would note a degree of inventory shrinkage, or missing liens against assets.

Valuation is one of the most important covering: "Assertions about valuation or allocation deal with whether asset, liability, revenue, and expense components have been included in the financial statements at appropriate amounts." It does not seem that classical valuations items related to inventory are a problem. The question of accounts receivable and warranties clearly are. Warranties in this case are not just, what is commonly considered, but also the pre-paid service plans and how their sales and associated expenses are matched.

SAS No. 31 states that: "assertions about rights and obligations deal with whether assets are the rights of the entity and liabilities are the obligations of the entity at a given date." This issue ties back to the assertion of existence. In this instance, we can ask if ownership has passed, at a given time or under a given set of circumstances. Bill Fleckenstein was also uncomfortable with the size of the "long-term investments and long-term receivables" and "long-term liabilities" line items. It was a balance sheet, Mr. Fleckenstein wrote at the time that "looks more like that of a financial institution than the box maker that it is."As well it should, having an independent financing arm.

The last are: "assertions about presentation and disclosure deal with whether particular components of the financial statements are properly classified, described, and disclosed."

For now, I believe that Dell has the ability to write the financials, but it appears that there are weakness in information collection..

For the five assertions it appears that valuation and rights and obligations are the areas of concern. There are going to be others that tie to it, but those two weaknesses would explain why it has taken so long to resolve the issues. The issues are technical and resolution may require a large amount of transaction testing.

The next step is to determine why there are problems, and the best way is to examine the COSO framework for relevant items.

There appear to be weakness in the control environment, probably in the area of authority and responsibility, and perhaps organizational structure. The sign of trouble is how slow Dell has been in even finding out if restatements are required. Share price has not been hurt, which shows that the system does work, though management may not know what is happening at any given time. Note that the founder stepped back in when trouble came.

For Risk Assessment, the company probably has no problems in the sense that they are protecting assets and can be said to be doing that properly. If that were not so, then gross margins would have fallen drastically. In any event word would have gotten around.

Control Activities are another area of mixed signals. First it is hard judge, policies and procedures, but as it relates to valuation of warranties, it is clearly lacking. This area is one where information should exist with sufficient historical detail to value the reserves be it uncollected account expense or others. Problems in those areas point to trouble at the top, simply because of the nature of the work. Other problems may emerge with options and that would be much the same. If these problems are in the production cycle too, then Dell will find it very costly to fix and maintain these controls.

Information and Communication appears not to be a problem related to these issues, but the amount of time spent on them shows that at response times are not very good or effective. Again the key task is getting product out the door, which is happening, but more than that, it is hard to tell if management reigns but doesn’t rule.

Monitoring is key to internal control system and the Audit Committee is doing the investigating of the current problems. One area of concern is other current assets, according to Bill Fleckstein

(seehttp://online.wsj.com/article/SB117530196851655338search.html?KEYWORDS=dell&COLLECTION=wsjie/6month

In 2004, the Other Current Asset doubled, while sales only grew by about 21%. This sort of red flag is what monitoring is supposed to prevent. Management might not know either, though it was a long time back.

The previously noted Fleckenstein comment how certain long term assets and liabilities made it look like a financial institution. Well, he describing the harm GAAP can do to financial analysis. In this case, as with many companies, like Cisco, Dell has a financing arm, which is consolidated. The problem is that financing entities are asset driven and the parent is sales driven. Many analysts consider self-financing a red flag because of the level of manipulation possible on the issue of revenue recognition.

Based on admittedly sparse information, it would appear that the company has control problems. The troubles are not sufficient to impact operations, but rather prevent accurate estimates such as reserves, and more importantly timely feed back and correction.

The question despite all the fanfare about GAAP and Internal Control, why is it that Dell is still going strong, if those two things were so important? Certainly, there has been a decline in shareholder value from a high in the low 40’s in December 2005 to about $25.00 now. The decline more or less followed absence of financial statements. 2006 was a bad year, but it wasn’t like Enron or Calpine for instance.

Why no crash? The market adjusted their forecasts to the max downside for warranties and possibly sales. There may have been other issues relating to the financing arm which makes these statements much less transparent. On the other hand, analysts also believed that sales were increasing, and that the management controls were effective.

These flaws have cost stakeholders money, but as the issues resolve, there will be considerable upside. Analysts employ far broader sources than most people believe, and are able to compensate for a lack of financial statement information. GAAP financials are nice to have but are not the sole means available to test performance or value.

Implications:  

On March 20, D&B announced that it has acquired First Research for $22.5 million cash on hand. The agreement provides the seller with an earn-out potential of up to $4 million based on financial performance.

First Research provides Internet-based marketing research and industry trends, for use sales professionals. D&B said that it plans to enhance its Hoover’s Inc. database with deeper, industry-specific content through the acquisition.

First Researchrevenue of $6.5 million, a nearly 30 percent increase over the prior year. Because of GAAP rules on deferred revenue, the acquisition will have no material impact or change 2007 earnings guidance.

The acquisition is of greater moment, than would be gathered from its price.

Analysis:

This acquisition and the way it was presented, combined with a description of D&B itself is interesting if for no other reason than that see:http://investor.dnb.com/phoenix.zhtml?c=123817&p=irolnewsArticle&ID=975864&highlight

The first thing that comes to mind is that D&B already has a product in this field. Yet they chose to buy. Buying competition or to get into a new market, is fairly standard, but the question is why this company in an area where D&B has a presence?

D&B answers the question in the press release, but the information is obscured by the other items it is lumped with:

-D&B's ability to successfully implement its Blueprint for Growth Strategy requires that it successfully reduce its expense base through its Financial Flexibility initiatives, and reallocate certain of the expense base reductions into initiatives that produce desired revenue growth.

-D&B's future success requires that it attract and retain qualified personnel in regions throughout the world.

D&B is pursuing two potentially contradictory goals: cutting costs and keeping good people, a combined goal at which many have failed.

The question of why becomes livelier based on its description of its assets:

D&B's global commercial database contains more than 110 million business records. The database is enhanced by D&B's proprietary DUNSRight(R) Quality Process, which transforms the enormous amount of data D&B collects daily into decision-ready insight

D&B, then is buying what is essentially a start-up, in an area where it has a product, in an industry where it truly has a franchise.

With 110 million business records and software, is it specifically necessary to buy what might be seen as redundant information?

-Its core information might not be in a useful format. The FBI had a similar problem and still is has not been able to put all its information in a common format.

-It software in this line, might not have been sufficiently flexible to meet customer needs.

Actually, what we are seeing is a diversified company essentially turning itself into a holding company, with all that entails:

-D&B will not do product development, but will buy when necessary, which is implicit message of cost cutting and revenue growth.

-The home office will be very lean, perhaps almost to the point of creating Sarbanes-Oxley issues.

-The real emphasis will be on the foreign/diversified operations.

Smaller ethical pharmaceutical companies routinely grow through acquisition, but the assets have patent protection, which is not available in other lines of business, like D&B’s.Further, cutting expenses while growing in foreign parts, can result in a management which reigns, but does not have the resources to rule the running of those operations.

Following this strategy will reduce assets available to change at the top, forcing management to respond to market challenges through purchase.At some point, competition may arise which cannot be managed or met in this way.

Implications:  

This article is very sparse, and the subject matter relatively old.

It discusses the decision by Levi Strauss to change auditors, leaving KPMG for PriceWaterhouseCoopers.

With KPMG in charge, the Levi Strauss had suffered a number of issues relating to restatements and KPMG’s assertions about a lack of internal control, though the specific troubles were not current.

Finally, Levi Strauss replaced them, after the release of the 2006 10-K.

Analysis:

This change has been a long time in coming and mostly likely was delayed due to the earlier problems. From page 75 of the 2003 10-K:

We restated our annual and quarterly financial statements for 2001, 2002 and the first two quarters of 2003, we did not file our Quarterly Report on Form 10-Q for the third quarter of 2003 on a timely basis and we received a material weakness letter from our outside auditors raising questions about our ability to identify and report timely and accurate financial information; we may experience breakdowns in our internal controls.

These problems resulted in two class actions suits from bond holders who purchased the Company’s bonds in the period from January 10, 2001 to October 9, 2003. There were also suits for wrongful dismissal

What should be noted is what the weakness actually involved rather than the statement above. The company is not an ‘accelerated filer’, and as such not yet subject to the requirements of fiscal year 2008 (with respect to the management report) and fiscal year 2009 (with respect to the independent auditor attestation report). The key, of course is that the company is still owned by the founder’s descendants, though a trust. Four voting trustees have the exclusive ability to elect and remove directors, amend our by-laws and take other actions which would normally be within the power of stockholders of a Delaware corporation. See page 19 of 2006 10-K:

Our approach to corporate governance may lead us to take actions that conflict with our creditors’ interests as holders of our debt securities.

Our principal stockholders created the voting trust in part to ensure that we would continue to operate in a socially responsible manner while seeking the greatest long-term benefit for our stockholders, employees and other stakeholders and constituencies. As a result, we cannot assure that the voting trustees will cause us to be operated and managed in a manner that benefits our creditors or that the interests of the voting trustees or our principal equity holders will not diverge from our creditors.

Thus management states quit clearly the truism that equity and debt holders have divergent interest, but because of the ownership structure, management and the owners have the power to make the decision stick.

Here are some important points:

-KPMG acted very quickly on the control weakness issues, much before the law would have mandated. For that reason and that reason alone it would seem that the problems were sever enough to force the auditor to act before it would have been strictly required.

-The law suits by debt holders may have more validity than some, if only because of the stated owner view of creditor interest.

-The financial statements say: “We will be required to evaluate our internal control over financial reporting under Section 404 of the Sarbanes-Oxley Act. Note that the company has not done so as yet.

The following conclusions can reasonable be drawn from the information provided above:

-KPMG moved before they strictly had to on the internal control issue. It would appear then, that the situation was bad enough for them to take action very early on.

-Levi waited until the dust had settled to get rid of KPMG. United Technologies did the same when their auditors told them the same. I am sure there was some embarrassment factor operating.

-The company is in a no-growth situation and has been borrowing relatively more.

-Management is a law unto themselves, and sees no convergence of interest with the debt holders.

-The owners believe and probably do, have sufficient information to manage the company, and the internal control systems to provide it. That is not the same as being able to create proper financial statements. Until the new rules came on the horizon, KPMG was willing to go along.

What we have is a bit different circumstance, where KPMG took preemptive action in the face of various control problems, the scope of which still has not been determined.

Implications:  

Mr. Kaplan, the head of Audit Integrity, is deeply disturbed by a Wall Street Journal article, “Companies Say Backdating Used in Days After 9/11” (March 7, 2007). Many companies rushed to grant options then claiming happenstance or rationalizing the action as a way to motivate executives in a difficult period.

With the statute of limitations approaching, SEC Chairman Cox has yet to decide who was damaged and what penalties might be placed on the companies involved. Further, is it fair that the costs come from the shareholders? Further he points out that the companies that were the worst offenders under-performed, despite of rich management compensation.

Mr. Kaplan believes that the individuals who did the backdating should pay and not the shareholders.

Analysis:

Self-dealing is built into the system. The trick is to make it unprofitable. Specialists on the NYSE are supposed to go against the trend in a strongly declining market. In times of huge declines, a great deal more money is made by specialist firms going with the trend than against it. Were these violators frog-marched, bound and shorn to the bar of justice? No, but the rules were changed to prevent these huge market declines, with methods, such as trading limits, developed on the commodity exchanges.

First, managers do back-date options and have done so for so long that it could be interpreted as a ‘custom and usage’ issue. The people responsible for preventing it are the Board of Directors, specifically the Audit Committee which has the means of enforcement through Internal Audit. Board members have insurance, and the ability to fire, then sue the people in question for misfeasance, say. In practice, there has very little disgorgement seen, though Mr. Kaplan mentions one, Ryan Brant. Board members also know that trouble can ruin their career: witness Judge Webster.

Note that the article mentions accounting charges, but does not say very much directly about specific market value losses associated with these adjustments. The nine companies’ equally weighted total return from October 31, 2001 to December 29, 2006 of the nine companies* was 59.16% well below the Russell 2000 return of 96.71% for the same period.

I would take another tack. The reason that the returns were lower for these companies was not only poor management, but also over-compensation by stock options which proved to be very dilutive on exercise. Think about it like this. Let’s say a company has absolutely stellar performance on a FCF or EVA measure. Then see what happens to share price when there is a lot of dilution through option exercise. I haven’t looked at the specific instances, but I would suspect that management might be more concerned about increasing volatility, hence potential option value, rather than growing share-holder value.

If for no other reason than bad publicity, many companies have stopped using option incentive plans. Others monitor option grants very closely, at the director level, to prevent dilution and protect shareholder interest. I believe that stock options and defined benefit plans are a thing of the past, and will disappear.

At one time, compensation related contingent liabilities were a popular vehicle for both firms and government. The promises were of negotiating value now, but would not become due for many years. Social Security is the best known instance. When it began, in the 1930’s almost no one lived to be 65, so the promises were cheap, and best of all not easily measured.

What we will finally see is a pay-as-you-go system for management compensation. Rather than a deferred liability you will see the cash expense recognized when the benefit is conferred. Service buyers will find it much more difficult to pay a cash price for what had been in the past potentially empty and costless promises.

I personally liked the Stern Stewart programs that put stock in a leveraged fund that vested benefits only after a certain period of time. Other things will work well depending on the management goals and characteristics of the industry in question. The one place they will remain key is in start-up ventures before an IPO where the employee is sharing part of the founders’ risk.

I believe that options, defined benefit pension plans and other arrangement that create an open-ended future liability will disappear, except in certain circumstances. Improved methodology and better systems show potential costs more accurately than before. With better information, the public realizes the need for legal protections, which turn such rights into actual rather than contingent obligations.

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*”The nine companies known to have backdated in the fall of 2001 are Affiliated Computer (ACS), Broadcom (BRCM), Brocade (BRCD), Corinthian Colleges (COCO), KLA-Tencor (KLAC), Monster Worldwide (MNST), Progress Software (PRGS), Take-Two Interactive (TTWO), and UnitedHealth (UNH).”

Implications:  

KPMP found, in it 2007 survey of the global construction industry, that twenty percent of respondents were aware of fraud in recent projects.

Richard Whittington, head of the firm’s construction practice was taken aback by the scale and the potential risks to the global economy and to the companies defrauded.

Analysis:

This link references the actual KPMG press release on the subject and provides a fuller description of the issues: http://www.kpmg.co.uk/news/detail.cfm?pr=2823

The article itself is most concerned with the availability of qualified contractors, not fraud. The survey itself was based responses of senior executives, at large and frequent procurers of construction services, including REITs, resource exploitation companies, utilities and governments. These individuals were queried on the current state of the industry, levels of satisfaction, project planning and contractor selection.

Forty two percent of the survey said that they were concerned with availability of qualified contractors, 75% saw a growth in demand for construction services and 39% anticipated a growth in construction expenditures.

Lastly and most interestingly, on-time delivery increased to 84% for the last project done, but over-budget projects increased to 35%.

In the study 80% of the surveyed were satisfied with their contractors, 20% claimed fraud. I would be interested to know the overlap between those claiming fraud and the merely dissatisfied. It must be noted that the respondents said they were aware of fraudulent activity but not whether they took action or more importantly on what facts and circumstances they based their judgment.

Comparable analysis doesn’t help much, but an audit of expenditures could provide adequate proof, if people were willing to pursue remedies. There are reasons why companies are not more concerned.:

-A building has intrinsic value associated with a well developed market. Except for truly bad projects or times of over-supply, a new building can be resold more than it cost to build.

-Construction is by definition is a sunk, controllable cost. Even if one over-pays, the only book expense is depreciation, and with current conventions, any excess expense is spread over a long period of time.

-In the US, tax benefits can help recoup any excess very quickly, and cynically, the higher the cost, the lower the tax bill. The exposure is low to cost over-runs.

The next issue was on-time delivery and cost over-runs, and it is encouraging that the percent of cost over-runs is much lower than the improved on-time performance level. If cost over-runs hurt, having a busted occupancy schedule can be ruinous.

I think the on-time performance is the most important measure in the study. Only when supply chains work and people are available can construction get gone on time. This fact bodes very well for the future with increased estimates for construction demand in coming years.

Contractors have to be careful about being over-extended. The problem is not equipment, but rather people. Running a large construction project well is a true gift, and any contractor is very concerned about keeping good teams in bad times. It appears that the better contractors will be able to grow very effectively building on present capability.

One question still open is the scope of the study. It included large procurers of construction services, but mentioned no banks and including them would add perspective on the whole industry, not just the top-tier. Since the lending is secured, the developer can finance conservatively 80% of the construction cost. Both parties, hopefully, will monitor these expenditures. After completion, a take-out loan is arranged to pay the construction loan with permanent financing.

It would be during construction that fraud would be detected. In practice, many lenders will not monitor the expenditures, an area of expected expertise, either from over-extension, or to solicit business. That is why the claimed incidences of fraud are so interesting: were they corrected or not. Claiming fraud looks better than admitting inattention, so fraud might not actually be fraud at all, but customer dissatisfaction, which would fit with the statistics.

Fraud is important, but was not really the most interesting part of the study. What is important is that the industry is growing and service quality high. Even cost over-runs can be seen as the result of on-time performance, which as we have seen is quite valuable. It seems the sector will provide many solid investment opportunities in the near term.

Implications:

This article is one of the best teasers I have seen and raises some supremely important issues relating to internal control weaknesses and if they have any import for investment decisions.

What the article is actually referencing is GM’s 10-K for 2006, filed March 15, 2007. GM disclosed, among other things that internal control weakness might preclude implementation of the company’s recovery plan. These disclosures are part of a longer history of accounting related issues culminating in a massive restatement in 2006.

Despite these very real issues, this article points out that analysts believe that demonstrated progress in reorganization, trump control weakness in determining shareholder valu