GLG News by Ronald Kiima, CPA

Implications: Will President Bush's recent nomination of two Democrats to the SEC make it more investor friendly?  Not likely!

Analysis: As per the referenced article, President Bush, at the behest of Senate Majority Leader Harry Reid (Democrat – Nevada), recently nominated two Democrats to fill commissioner vacancies at the SEC.  Interestingly, both nominees are former SEC staff attorneys.      

As a matter of background, the SEC is headed by a five-member commission with each commissioner, in the normal course, serving a staggered five year term.  Commissioners are limited to serving two terms.  

The President is empowered to appoint all SEC commissioners subject to the advice and consent of the Senate.  No more than three commissioners may be members of the President’s political party.  The current Republican Commissioners are Christopher Cox (Chairman), Paul Atkins and Kathleen Casey.  President Bush’s nomination of Luis Aguilar and Elisse Walter, if approved by the Senate as expected, will restore the SEC to a full slate of five commissioners – three Republicans and two Democrats.         

While I have no firsthand knowledge of Luis Aquilar, various news accounts cite him as being an outspoken critic of the Sarbanes-Oxley Act of 2002 (“SOX”).  As a former SEC Assistant Chief Accountant, I am quite comfortable in my belief that such an anti-SOX position, if in fact true, would be relatively rare among current and former SEC staffers.     

In contrast to Aguilar, I have both first-hand and second-hand (via my former SEC legal colleagues) knowledge of Elisse Walter as our former careers with the SEC’s Division of Corporate Finance overlapped by several years.  My collective knowledge of her is one of being a politically astute lieutenant who rarely dared to challenge the often self-serving positions and interpretations of corporate registrants and their agents.  Such impression would appear consistent with the views of others recently expressed in the media.   

Given the preceding and the continuing dominance over the Commission of the politically-savvy Chairman Christopher Cox (former Republican Congressman from Orange County, CA), whose long-standing and zealously pro-business positions are well-known, I would not expect the appointments of Aguilar and Walter to have any substantive impact upon the current “investors be damned” posture of the SEC’s political leadership.               

Implications: The subject article provides some interesting insights into the upward reversal in the number of securities class-action lawsuits filed during 2007.  Given such, I thought it might be fitting to offer my personal insights into what I continue to believe is the most common, yet rarely noticed, accounting error. As in prior years, inappropriate depreciation and amortization methodologies once again gets my nomination for Accounting Error of the Year.  Unfortunately, absent some unforeseeable improvement in oversight by corporate auditors and the SEC, I suspect that I will again be making the same nomination this time next year.      

Analysis: In the course of reviewing the financial statements of public companies, rarely a day goes by that I don’t encounter inappropriate depreciation and amortization accounting policies and practices.  I suspect that in many instances these inappropriate depreciation and accounting policies and practices are inadvertent given the thoughtless inclination by many accountants to merely default to a straight-line methodology as it facilitates bookkeeping.  However, in many other cases, I suspect that straight-line depreciation or amortization is utilized by managements to inflate near-term earnings.    Simply put, the manner in which a company depreciates or amortizes an asset, whether tangible or intangible, should materially parallel the economic benefits (e.g., revenues, cash, etc.) it realizes from the utilization of such asset.  Unfortunately, companies routinely utilize straight-line depreciation or amortization despite the pattern of economic benefits being other than ratable.  In particular, as the economic benefits realized from a technologically or competitively sensitive asset are often front-loaded and dissipate over time on an accelerated basis, companies should be depreciating or amortizing such asset on an accelerated basis as well so as to provide for a better matching of revenues and expenses.  To do otherwise, which I note is too often the case, results in artificially inflated earnings in the early years and artificially deflated earnings in latter years, compounded by an increasing probability of asset impairments or losses on sales/disposals being recognized downstream.  Accordingly, analysts should attempt to adjust their earnings models accordingly, particularly for any unsupportable disparities among peers.

Implications: Few other disclosures give as much visibility into the integrity of a company’s reported results like the SEC’s Schedule II – Valuation and Qualifying Accounts. Unfortunately, despite such schedule being required of most public companies, few companies seemingly fully comply. The absence of otherwise required data, or worse, the outright omission of the schedule in its entirety, should raise investor concerns that a company may be engaging in some degree of inappropriate earnings management.

Analysis:

As a matter of background for those unfamiliar with Schedule II, the vast majority of U.S. listed companies are categorized by the SEC as “commercial and industrial companies” thus making them subject to the requirements of Article 5 of Regulation S-X and its underlying rules. Rule 5-04 of Regulation S-X requires that an audited Schedule II, as prescribed by Rule 12-09 of Regulation S-X, be filed in support of valuation and qualifying accounts included in each fiscal year-end balance sheet and that the schedule cover each fiscal period for which an audited statement of operations is required to be filed [typically the latest three fiscal years]. Rule 12-09 of Regulation S-X then sets forth the form and content of Schedule II as follows:

Column A	Column B	Column C Additions		Column D	Column E
Description 1	Balance at beginning of period	(1) Charged to costs and expenses	(2) Charged to other accounts -- describe	Deductions -- describe	Balance at end of period

¹ List, by major classes, all valuation and qualifying accounts and reserves not included in specific schedules. Identify each such class of valuation and qualifying accounts and reserves by descriptive title. Group (a) those valuations and qualifying accounts which are deducted in the balance sheet from the assets to which they apply and (b) those reserves which support the balance sheet caption, Reserves. Valuation and qualifying accounts and reserves as to which the additions, deductions, and balances were not individually significant may be grouped in one total and in such case the information called for under columns C and D need not be given.

Simply put in today’s accounting terminology, Rules 5-04 and 12-09 of Regulation S-X, including the accompanying instructional footnote above, requires, to the extent not otherwise disclosed directly in the notes to the accompanying financial statements, that a company provide an itemized roll-forward of the activity in each of its contra-asset accounts and liability reserves. Given their inherent uncertainty, contra-asset accounts and liability reserves typically constitute the soft underbelly of any set of consolidated financial statements. Thus, contra-asset accounts and liability reserves routinely pose the greatest accounting challenges to ethical managements as they attempt to derive the best possible estimates. Unfortunately, ethically-challenged managements often exploit the softness of contra-asset accounts and liability reserves to engage in inappropriate earnings management, i.e., tucking away earnings for a rainy day.

Admittedly, Rule 4-02 of Regulation S-X permits the exclusion of otherwise required disclosures to the extent that the subject amounts are not material. However, it is often apparent that Schedule II omissions by a company are based exclusively on the quantitative immateriality of an ending contra-asset or liability reserve balance to applicable balance sheet measures. Unfortunately, upon further scrutiny and analytical deduction, it is often apparent that the associated provisions or charge-offs were material to a company’s results of operations for one or more reported fiscal years.

Consistent with the underlying premises of SEC Staff Accounting Bulletins Nos. 99 and 108, any materiality assessment must also consider, among possible qualitative aspects, the quantitative materiality of the associated provisions and charge-offs to the statements of operations. Thus, any immateriality assertion by a company’s management that has been predicated exclusively on balance sheet measures is, at best, inappropriate and, at worst, an attempt to conceal inappropriate earnings management practices.

Furthermore, even in those all too rare instances where a company furnishes what would appear to be a fully compliant Schedule II, significant variability and/or unusual activity or financial relationships in the contra-asset accounts or liability reserves are unexplained, thus again leading one to question the integrity of reported results. Where the underlying activity or financial relationships beg for explanation, a company should provide sufficiently detailed explanations in their accompanying Management’s Discussion and Analysis of Financial Condition and Results of Operations pursuant to Item 303 of Regulation S-K. Best practices would further suggest providing accompanying explanatory footnotes directly on the face of Schedule II as well.

With that said, I challenge Corporate America to pull back their blinds and let the sunshine in…all the way in!

 

 

Implications: This article raises the question as to whether the U.S. Securities and Exchange Commission (“SEC”) will ultimately mandate that domestic public companies report their financial results pursuant to International Financial Reporting Standards (“IFRS”).  I believe, as a former SEC Assistant Chief Accountant who had oversight responsibility for numerous foreign private issuers, that the answer is an unequivocal “yes.” 

Analysis:

For approximately two decades, the SEC and Financial Accounting Standards Board (“FASB”) have been diligently working with their respective counterparts abroad to converge U.S. generally accepted accounting principles (U.S. GAAP) with the generally accepted accounting principles of other first-world countries.  This ongoing sovereignty -surrendering, give and take exercise currently targets substantial convergence by 2009.  The SEC has increasingly made it known for years, under both Democratic and Republican administrations, that upon reaching substantial convergence, if not somewhat before, that it will progressively eliminate the current requirement that foreign private issuers provide detailed footnote disclosures reconciling any material differences with U.S. GAAP…thus, the “political carrot.” 

With respect to the question posed by this article as to whether U.S. public companies will be allowed to continue to report under U.S. GAAP subsequent to substantial convergence with IFRS, again targeted for on or before 2009, I believe that U.S. GAAP will remain a reporting option but only for a period of time sufficient for the regulatory, investing and academic communities to become more comfortable with IFRS.  However, time is of the essence for these communities as I believe that the SEC views us as being well into the transitional period.  Furthermore, I believe that the SEC, regardless of the political persuasions of the then President and SEC Chairman, will continue to aggressively push such transition so as to ultimately mandate IFRS for all U.S. listed companies, foreign and domestic.  Thus, the death of U.S. GAAP is foreseeable!       

Implications:  

If they do not already do so, analysts need to begin proactively adjusting their models to reflect the assets and liabilities underlying “operating” leases onto the books of the companies they follow.  It is no longer a question as to whether many current operating leases will go onto the books, its merely a question of when and how many!

Analysis:

As a former Assistant Chief Accountant in the SEC’s Division of Corporation Finance, I can attest to the fact that there is probably no area of the current accounting literature that is disliked more by the SEC’s accounting staff than lease accounting (i.e., SFAS 13 and related pronouncements).  Additionally, as a technical accounting consultant, I can further attest to the fact that companies in need of facilities and equipment routinely structure related transactions within a cat’s whisker of the bright-line triggers within the lease accounting rules to avoid on-balance sheet “capital” lease treatment.  As a result, most companies are able to ultimately characterize the vast majority of their leases as off-balance sheet “operating” leases, whereby they merely record periodic rent expense.  In short, with a tweet here and a tweet there, a company with savvy accounting advisors can avoid booking millions, if not billions, of assets and liabilities. 

 

As to which “operating” leases will ultimately be required to be reflected on the books, that is a difficult question to answer from a purely quantitative perspective.  However, it is safe to assume that the SEC and FASB, consistent with other more recent changes in the accounting literature, are going to qualitatively focus on which party, the lessor or the lessee, primary benefits from the underlying asset over the majority of its estimated useful life.  If a company is deemed to be the primary beneficiary, on the books it will likely go!  And its about time!!! 

Implications: Given the endless belly-aching by Corporate America and its agents about how draconian Sarbanes-Oxley is, even in the midst of a seemingly never-ending stream of accounting scandals, I thought that a little comical perspective may be in order.  With that said, I submit this article which sets forth the Chinese alternative to Sarbanes-Oxley!

Analysis: Admittedly, this article doesn’t provide much in the way of takeaway value.  However, given the holiday season, I thought a little comical relief may be in order.

Implications:  

The Public Company Accounting Oversight Board’s recent dismantling of AS2, its guide for auditors in their assessments of corporate internal controls over financial reporting, at the persistent urging of SEC Chairman Christopher Cox is further evidence of President Bush’s underlying agenda to disembowel Sarbanes-Oxley (“SOX”).  Unfortunately, the consequences of such disembowelment will likely be disproportionately borne by investors in smaller public companies.   

Analysis:

Few would dispute that a cost/benefit refinement of AS2 is now appropriate given the insights provided by a couple of years of real-world applications.  However, the outright repealing of AS2 has less to do with its cost/benefit shortcomings and more to do with the Republicans desperate attempt to recapture Corporate America’s affections in time for the 2008 elections, particularly since their efforts fell significantly short for the 2006 elections.  AS5, the proposed replacement for AS2, will provide for, among other liberalizations, a kindler and gentler examination of the internal controls over financial reporting for smaller public companies.  Such proposal comes after several postponements by the SEC of the SOX 404 reporting deadline for smaller public companies, currently scheduled for fiscal years ending after December 15, 2007.  The SEC also recently provided smaller public companies with another substantial break by not requiring that their auditors attest under SOX 103 to the effectiveness of their client’s internal controls over financial reporting until the following year, that being fiscal years ending after December 15, 2008.  As a former Assistant Chief Accountant with the SEC’s Division of Corporation Finance (but a “law and order” Republican Capitalist), the question I would like to pose to President Bush and Chairman Cox is this: “How do you reconcile these continuing regulatory accommodations for smaller public companies to the historical statistics which indisputably demonstrate that the smaller the company the higher the probability of materially misstated financial statements?”

Implications:  

Anonymous but supposedly knowledgeable sources cited in recent news articles assert that premeditated fraud was involved in the granting of certain stock options at Apple.  With such assertions once again comes the speculation as to whether Steve Jobs will survive Apple’s stock option scandal.  As a former Assistant Chief Accountant with the SEC’s Division of Corporation Finance, this posting attempts to provide guidance to those attempting to assess the situation. 

Analysis:

I believe the question of Job’s survival comes purely down to whether he had any personal involvement in the orchestrating of any fraudulent activities underlying inappropriately granted or backdated stock options.  To the extent that Jobs had any such involvement, it is highly improbable that he will survive as any civil and criminal prosecutions, or settlements thereof, by the SEC or DOJ, respectively, will certainly seek (and likely obtain) his removal from Apple. 

 

In its October 4, 2006 Form 8-K, Apple acknowledged, among other items, the following:  “In a few instances, Apple CEO Steve Jobs was aware that favorable grant dates had been selected, but he did not receive or otherwise benefit from these grants and was unaware of the accounting implications [emphasis added].”  If the preceding representation is ultimately proven to be the full extent of Jobs’ knowledge and involvement (i.e., the absence of any fraudulent intent), then I continue to believe that Jobs will be allowed to retain his current roles with Apple.  However, consistent with the “reckless in not knowing” underpinning of many SEC enforcement actions, I continue to believe that Jobs will likely be subjected to a cease and desist order prohibiting him from any further violations of the federal securities laws.   

Implications: Vitesse had previously attributed, without any further elaboration, its termination of KPMG to a “lack of independence” which certainly raised a few eyebrows given the extensive prohibitions of Sarbanes-Oxley. As addressed in this article, Vitesse has now clarified that such “lack of independence” is solely prospective in nature given that it is considering legal action against KPMG apparently for failing to detect the various improprieties underlying its now acknowledged “accounting train wreck.”

Analysis:  

Given what I witnessed during my nearly nine years with the SEC’s Division of Corporation Finance, I am nearly incapable of being shocked. However, I do find myself astonished at the gross inadequacies that seem to come to light daily in the audits of various public companies. While I acknowledge that an audit, as a consequence of balancing costs with benefits, is only intended to provide “reasonable assurance” that a company’s financial statements are “fairly stated, in all material respects,” I cannot reconcile to myself the utter lack of common sense applied in certain audits.

While I can find some sympathy for an auditor which did not detect stock option backdating given the overall complacent environment created as a result of APB 25’s not requiring any expense recognition for [otherwise seeming] “at-the-money” stock option grants, I am totally befuddled as to how any technology company can materially manipulate its revenue recognition right under the nose a competent audit firm. As historically the vast majority of SEC imposed financial statement restatements and related enforcement cases have had an element of revenue recognition manipulation to them, and a majority of those since the early 1990s have involved technology companies, an auditor of a technology company should get two things right if nothing else…cash and revenue!!!

In no way should this diatribe be misinterpreted as being supportive of Vitesse. A company’s financial statements are the responsibility of its management, period…no ifs, ands or buts. Therefore, as a self-appointed juror here, I would have to hold my nose while awarding Vitesse or any other company any compensatory and/or punitive damages from an auditor. However, any auditor that can’t even get the obvious stuff at least materially correct deserves to significantly share in any pain inflicted upon shareholders!

Implications: This article sheds much needed light upon what I believe to be the most pervasive and significant internal control weakness among public companies…that being the absence of current and relevant technical accounting and financial reporting expertise on audit committees. As an audit committee truly serves as the last line of defense to the dissemination of erroneous or fraudulent financial reporting, it is imperative that analysts be more attentive to the technical qualifications of its members.

Analysis: Pursuant to the Sarbanes-Oxley Act of 2002 (“SOX”), a public company must either (i) have at least one member of its audit committee that qualifies as an “audit committee financial expert,” as defined, or (ii) disclose annually its basis for the absence of such an “expert.” Unfortunately, in response to the objections expressed by many companies while SOX was being drafted, Congress diluted its initially contemplated definition of “audit committee financial expert” to the point where nearly anyone with an elementary understanding of accounting, financial reporting, internal control and corporate governance qualifies. As a consequence, few audit committees have been technically strengthened from that of their pre-Enron era predecessors.

Consistent with my observations over twenty plus years of scrutinizing public companies, including nearly nine years with the SEC’s Division of Corporation Finance, very few audit committees have even one member that is truly proficient in technical accounting and financial reporting matters. Admittedly, many audit committee members have impressive biographies, commonly including tenures as audit partners with major international accounting firms or chief financial officers with public companies. Unfortunately, many of these otherwise notable individuals became increasingly consumed, out of necessity, with administrative, operational or marketing matters as their careers progressed, which inversely resulted in their technical accounting and financial reporting knowledge progressively deteriorating over the years. As a consequence, these otherwise impressive individuals, with all due respect, are rarely up to the task of monitoring and assessing the application of increasingly complex accounting and financial reporting rules and regulations.

Thus, I believe that it is imperative that analysts thoroughly scrutinize the current and relevant technical accounting and financial reporting expertise of the audit committee members of companies with which they contemplate any investment. To the extent that there is not at least one audit committee member that possesses current and relevant “real world” technical experience in assessing the application of increasingly complex accounting and financial reporting rules and regulations (i.e., a true “audit committee financial expert”), an analyst must acknowledge that the risks associated with their investment is unnecessarily elevated.