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Did Accounting Firms Miss The Subprime Numbers?

The New York Times brutalized the accounting industry today by suggesting that auditors should have caught bad numbers on the books of financial companies much earlier. The paper reports that "attention is turning toward yet another steward of financial reporting ensnared in the subprime debacle: accounting firms."

The viewpoint may not be entirely unfair and its goes to the heart of a question which has been raised about accounting firms on countless occasions. Why do the stewards of letters approving the P&Ls and balance sheet of firms get their analysis wrong so often?

The next question is whether the subprime crisis will cause shareholders suits against the large accounting operations, another part of the cycle of blame which hits when public companies begin to fail.

Douglas A. McIntyre

State Street, Not Immune To Subprime (STT)

State Street Corporation (NYSE:STT) has announced that it will record a net after-tax charge in the fourth quarter of 2007 of $279 million, or $0.71 per share. The charge is to establish a reserve to address legal exposure and other costs associated with the underperformance of certain active fixed-income strategies managed by State Street Global Advisors, the company’s investment management arm, and customer concerns as to whether the execution of these strategies was consistent with the customers’ investment intent.

Can you say "fiduciary responsibility" issues? 

In aggregate, the reserve will be $618 million on a pre-tax basis. The impact to earnings of the net charge, after taking into account the tax effect of the reserve and associated lower incentive compensation cost, will be $279 million.

State Street also announced that James Phalen, executive vice president and head of international operations for investment servicing and investment research and trading, is returning to SSgA as interim president and chief executive officer. Phalen succeeds William W. Hunt who has resigned from State Street.

Earnings per share for 2007 are expected to be between $3.42 and $3.45 per share, and return on equity is expected to be approximately 13%, all on a GAAP basis.  On an operating basis 2007 earnings per share is expected to be between $4.54 and $4.57 per share and return on equity is expected to be approximately 17.5%.  We have a First Call estimate of $4.19, although we'd caution that these charges will make any direct comparison 'cloudy.'

Jon C. Ogg
January 3, 2008

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VeriFone Does The Unthinkable (PAY)

VeriFone (NYSE:PAY) is seeing shares crushed today after the company issued a release stating that it was going to restate financial results and quarterly financial statements for 2007.  This is due to errors in accounting related to the valuation of in-transit inventory and its allocation of manufacturing and distribution overhead to inventory that affects the cost of revenues.

Its revenue forecast for Q4 actually looks above plan, but the results are being delayed and no one wants to trust a company that restates recent results.

It is under a planned share sale under a 10b5-1 plan, but the CEO sold 43,300 shares just last week and that will bring additional criticism over the timing of this news.  This will draw additional fire today.

This seems to be the worst drop in the share price in memory.  "Accounting irregularities" and "sudden financial restatements" are never good things to hear.  We caution against believing that these huge drops are immediate buying opportunities because these historically only pop a bit before drifting lower.  That being said, we do expect that some who have been waiting for a chance to buy the stock after its huge run since early 2005 may have a hard time resisting the decision to buy shares. 

VeriFone shares opened down huge at just under $30.00, and now shares are down 46% at $25.50 in early trading.  Morgan Keegan was the first of the firms to downgrade this almost 60 days ago, but you can expect the other analysts may have to bail on backing a company after a blunder like this.  VeriFone makes the credit and debit card transaction swipe machines you use at the grocery store and elsewhere. 

Jon C. Ogg
December 3, 2007

Six Stocks That Could Go To Zero (CHTR)(JRC)(AMD)(XMSR)

In the current credit environment, there are several fairly big companies that could get in enough trouble that it would wipe out the common shareholders. The ones in the financial industry like Countrywide (CFC) and E*Trade (ETFC) are obvious. But there are others outside finance that have huge debt loads which can no longer be fre-inanced to buy them time, especially if the core businesses are not doing well.

Charter Communications (CHTR) Charter now has over $19 billion in debt and a market cap of only $486 million. It stock has recently fallen from $4.93 to $1.20. In the last quarter, Charter had $105 million in operatng income on $1.525 billion in revenue. Interest expense was $452 million. Charter is up against increasing competition from satellite TV and telecom companies. It does not have the capital it needs to upgrade its infrasturcture to stay in the competitive game.

Journal Register (JRC) The newspaper chain had operating income of $22 million last quarter on revenue of $121 million. Interest expense was almost $10 million. Long-term debt is over $700 million, and revenue at JRC and most newspaper companies is dropping at about 7% year-over-previous year. Its stock has fallen from over $8 to about $2 over the last year.

AMD (AMD) The chip company recently got a cash infusion of $622 from the Abu Dhabi government's investment arm. When the money came in, the stock traded above $13. It has since fallen to $10.27. Wall St. is not convinced that AMD can compete with Intel (INTC), at least not with its current capital structure. In the last quarter, AMD had an operating loss of $226 million on revenue of $1.632 billion. Interest expense was $95 million. Debt, much of its taken on witht the purchase of graphics chip company ATI, now runs almost $5.4 billion. Early word is that the market is not impressed with the company's next-generation Barcelona chip. AMD would need a huge turnaround in a short time to handle its debt problems.

XM Satellite (XMSR) XM does not like to talk about it, but it needs to merge with Sirius (SIRI) for financial reasons as much as anything else. The company has total liabilities of over $2.4 billion including long-term debt of almost $1.5 billion. Its subscriber growth rate has been slowing each quarter and in the September period it had an operating loss of $113 million on revenue of $257 million. Interest expense was $27 million. Less than two years ago, XM traded for over $30. It now trades at under $14. Imagine what would happen if the merger is killed.

None of these companies is likely to fail in the sense that it will cease to operate, but it is not hard to imagine that all of them will be forced to restructure, and common sharesholders are likely to get nothing.

Douglas A. McIntyre

Would AT&T (T) And Verizon (VZ) Follow GM (GM) And Off-Load Liabilities?

"AT&T Inc.(T), the biggest U.S. phone company, and No. 2 Verizon Communications Inc. (VZ) may follow General Motors Corp. (GM) in trying to shift retiree health-care liabilities to a union-run fund, a move that has helped boost GM's shares 39 percent this year". At least Bloomberg thinks so. 

International Union of Electronic Workers-Communication Workers of America  represents workers at AT&T, Verizon and Qwest Communication International Inc. in Denver, the second-, fourth- and 13th- largest companies ranked by retiree obligations in the S&P 500. The union will negotiate with Verizon and Qwest next year and AT&T in 2009, according to Bloomberg.

What could the move mean for telecom stocks? Based on the $3.5 billion Verizon spends each year on current and retired employee health costs, a great deal. GM's stock got a 25% "healthcare fund settlement" benefit when it worked out its deal with the UAW.

That would translate into Verizon's shares moving from their current $45 to over $56. Is that number based on exact calculations of health costs to balance sheet to share price? No. But it is probably in the ball park.

Douglas A. McIntyre

General Electric (GE) Financial Changes Immaterial: A Sideshow Compared To Catalysts

General Electric's (NYSE:GE) 10-Q filing included some accounting changes that will have an impact on results from the years 2000 to 2004.  Before you have a conglomerate accounting irregularity freak-out session, there are many other things to worry about elsewhere like the weakening stock market because these changes to results are in reality quite small and really do not look company-wide.  Sure, this may make cover stories for the weekend versions of the Wall Street Journal and will be in other papers this weekend, but that's because it is easier to garner more interest if there are concerns and possible scandals to report.

If you follow "Legal Proceedings" then this is not really anything GE investors should worry about.  Based upon what I was able to garner from a recent luncheon with GE's CFO Keith Sherin companies this spread out and anywhere close to this large will have reviews in some form or another in one unit or another for the end of days.  That is the price in a post-Enron financial world.  If you want a prediction right here and right now you heard it from me: this isn't the last restatement or accounting change you'll ever see, and this isn't likely a systematic problem spread across General Electric.  Take a look at some of at the copied verbatim for exact wording out of the 10-Q:

In connection with the SEC’s investigation, the Audit Committee of our Board of Directors, with the assistance of independent counsel, undertook a review of the Rail transactions. Based on this review and as further described below, we have determined that revenues had been inappropriately accelerated so that they were recognized in the fourth quarter of each of the years 2000 through 2003 rather than in the first quarter of the following year. Our management and Audit Committee determined that the effects of the Rail transactions are not material to our financial statements under applicable SEC guidance and accounting literature. If the transactions had been recorded in the appropriate quarters, the effects on GE’s consolidated revenues, earnings before income taxes and accounting changes and net earnings would have been less than 0.2% in each year.

In each of the years, basic and diluted net earnings per share would have been unaffected had these transactions been correctly recorded, except that, because of rounding, (1) 2003 diluted net earnings per share, understated by $.0009, would have increased by $.01, and (2) 2002 basic net earnings per share, overstated by $.0022, would have decreased by $.01. In addition, in fiscal years 2001 through 2004, basic and diluted net earnings per share, as originally reported, would have been unaffected if these transactions had been correctly recorded.

The effects of the Rail transactions on revenues and profit for the segments containing the Rail business, as originally reported, from 2000 through 2004 would have been less than 4.5% in all annual and quarterly periods other than the fourth quarter of 2002 and the first and fourth quarters of 2003. Industrial Products and Systems segment revenues and profit were overstated by 8.8% and 14.5%, respectively, in the fourth quarter of 2002 and understated by 30.0% and 35.4% in the first quarter of 2003; Transportation Systems segment revenues and profit were overstated by 22.6% and 16.6%, respectively, in the fourth quarter of 2003. Transportation Systems was the smallest of GE’s 13 segments in 2003, representing 1.9% of consolidated revenues and 2.3% of consolidated earnings before income taxes and accounting changes.

In the Rail transactions, we transferred locomotive titles but not sufficient substantive risks and rewards of ownership to financial intermediaries. One quarter after title transfer, we delivered those locomotives to the ultimate railroad customers. Our Audit Committee has determined that, in connection with the Rail transactions, several individuals in our Rail business and in our capital markets group engaged in intentional misconduct that misled those responsible for accounting oversight and further that the transactions were also not adequately examined by those responsible for accounting oversight.

Ultimately you will have to decide on your own how material this is.  Back in February we noted how the "Material Weakness" section in the Annual Report was not all that material for a company this large and with this many units.  If this was very material, then there be changes to internal controls and procedures in the filing and those were deemed effective. I won't bother trying to explain all of the changes going on in accounting, but in the luncheon I attended in New York City with GE's CFO Keith Sherin this week one of the points that the CFO discussed was the ongoing accounting reviews and changes.  He specifically noted some derivative restatements and said that FAS-133 reviews were ongoing.  My own impression is that this is being mandated not just at GE but is much more systemic with conglomerates and SEC reviews in general, particularly as Mr. Sherin noted that FAS-133 needs some simplifications and some more common sense rubbed over it. 

Mr. Sherin gave a broad overview of the company, and my own personalysis interpretations will tell you in as close to matter of fact as an outsider can that this is not an issue keeping anyone up at night other than the actual motions and time involved.  There are many more positive engines (no pun intended) right now that are acting as drivers for the company.  Keith Sherin used the term "growth company" more than once, and with a broad 20% target for return on capital each year you can see why. 

Unfortunately the stock market has the sniffles, that turned into a full blown cold Thursday, and if Friday's end of day trading was any indication then the doctor is worried the market may have to go to the doctor if the patient doesn't improve this weekend.  Hopefully the market will have a bit more stabilized trading next week, because we have a series of segments we'll be running on General Electric with both sides of the coin on each.  But after being able to give this a couple days of segmenting analysis the company sure seems like it has a hell of a lot more going for it in the near future compared to accounting worries that can be blown way out of proportion if they are 'spun' with a crafty pen.  There is always some pause that has to be given now any time there is any word of accounting restatements, but remember that the media can sell you more newspapers and keep you watching longer if they can convince you a scandal is looming. 

You should be worried much more about the good old stock market in general dragging GE than this issue, or at least that is the opinion of yours truly.  This stock was holding its own quite well and managing to hold $40.00 until the market cracked and if you look at and compare the intraday charts on GE versus the DJIA and the S&P 500 this week then you can see that the DJIA and S&P 500 are pulling GE down rather than GE acting as a catalyst hurting the markets.  Anyhow, it is always safe to assume there can be more disclosures such as this, but so far GE still looks like it wants to act as a leader when the market goes up rather than a drag.  Stay tuned next week as we roll out some of these feature stories on various aspects of the company with analysis on each.

Jon C. Ogg
July 27, 2007

Jon Ogg can be reached at jonogg@247wallst.com; he does not own securities in the companies he covers.

Statement 159: Second Thoughts? Guilty Consciences?

From AAO Weblog

Less Than Gleaming Sterling

From AAO Weblog

Bausch & Lomb: Buyout Based On What?

From AAO Weblog

LMT - Lockheed Martin: Change in Accounting Procedure

The outlook for Lockheed Martin is stable. The US Defense budget is expected to rise a meager 14.3% over the next 4 years (from $439B in 2007 to $502B in 2011), roughly 3% a year. This however does not include special supplementary budgets for the war in Iraq, the war in Afghanistan and the war on terrorism (which is less specific).~

Analysts are expecting a continued improvement in margins. What is little known is that part of this improvement is due to an accounting change.

LMT has five divisions;

Aeronautics (31%) - F16, F-22, F-35

Electronic Systems (29%) - Missiles

Space (18%) - Satellites

Integrated Systems (11%) - Communications

IT Systems & Services (11%) - Information Technology

We estimate for 2007 a 3% decline in revenue for the Aeronautics division and a 6% decline for the Space division. The decline is Space should be offset with an 11% increase in the IT division.

Change in Accounting

Instead of awarding a contract to LMT, then sub-contracting components to others, LMT formed the United Launch Alliance with Boeing (BA). According to this new procedure, contract revenue does not appear on LMT's statements, only the relative portion of income. This will automatically improve margins. Margins could hit 10.5% in 2007, compared with 8.9% for 2005.

When comparing margins in the future, this change has to be taken into account for the Space division. The higher margin does not necessarily imply an improved execution environment.

There are no changes in our estimated 2007 EPS; $6.20. We realize that Q1 contains $0.21 in extraordinary gains; however we anticipate an offset in Q3. LMT recently guided upwards from $5.80 - $6.00 to $6.20 - $6.35.

US Navy Cancellation

We (CrossProfit) view the Navy's cancellation for a new prototype shallow water warship as a blessing in disguise. LMT should concentrate on aeronautics. When getting into something that you are second best at, production overruns are inevitable. General Dynamics (GD) should fair better in this naval commission though rumors have it that G-D could use a little help from Poseidon.

Disclosure: No conflicts.

http://www.crossprofit.com

First Charter’s SAB 108 Story

From AAO Weblog

OFHEO: Still More Work To Do At Fannie & Freddie

From AAO Weblog

Recent Action In Restatement-Land

From AAO Weblog

Tenet Healthcare: Settled With The SEC

From AAO Weblog

A Camel’s Nose Under A Tent: Sure Looks A Lot Like The SEC

From AAO Weblog

Echostar’s 108 Dish (DISH)

From AAO Weblog

Dover Downs: Lucky 108!

From AAO Weblog

Another revenue recognition correction, this one in the books and records of Dover Downs Gaming & Entertainment.

Lincare Synchs Up Revenues

Triarc’s Tri-108 Adjustment

Back on the Island of Weird SAB 108 adjustments…

Another positive adjustment to beginning 2006 retained earnings is disclosed in Triarc’s 10-K It also contains one of the better descriptions of how the firm assessed the ongoing errors before SAB 108 and waived the adjustments: it’s an actual statement that they’d assessed a particular error using the rollover method, enabling them to pass on it.

Apria Healthcare: Synchronizing Revenues With Services

From AAO Weblog

Finally, a “normal” sort of SAB 108 adjustment… normal, at least, in the context of what you’d expect.

Home healthcare provider Apria Healthcare Group went the cumulative-adjustment group in their 10-K filing for 2006, with their correction of revenue recognition. It’s exactly the kind of error you’d expect to see corrected a la SAB 108: a known error for years, immaterial when viewed one way - the rollover method, in this case - but material when you look at it in the context of the iron curtain.

(If the terms “rollover” and “iron curtain” leave you scratching your head, click here for some help.)

Apria’s issue: they bill customers monthly for the use of equipment. That monthly bill is actually a prepayment on the part of the customer for the right to use the equipment for a month - but unless that billing takes place on the first day of the month, a portion of the billing is for revenue to be recognized in a subsequent month. Apria recognized revenue based on the billing, instead of the period in which the service was actually provided. The expense associated with those revenues also get recognized out of synch with the period in which the service is actually rendered, too. Net effect: early revenue and expense recognition.

To correct it, Apria established a deferred revenue account for $32.3 million and a deferred expense account for $22.7 million, implying about a 30% gross profit on such services. The after-tax effect hitting retained earnings: a charge of about $5.5 million. While any one year’s error might have been immaterial, catching up those all of the errors would have been material to any one year’s earnings.

A pretty basic principle - match revenues/expenses with the periods in which they’re earned and incurred - now being applied properly because of the amnesty provided by SAB 108. One wonders what would kind of scenario would instigate corrections everywhere if SAB 108 hadn’t come along.

http://www.accountingobserver.com/blog/

AES: Restating Due To Remediation

From AAO Weblog

Monday, AES Corporation issued a non-reliance 8-K covering its financials for 2006 to date and the years ended 2005, 2004, and 2003.

The company is still investigating, but it will restate for a variety of reasons. From the 8-K:

“The errors identified by the Company relate primarily to the following categories, which may change before the accounting review is finalized:
· Accounting for derivatives
· Capitalization
· Certain errors, including depreciation adjustments in the Company’s subsidiaries, C.A. La Electricidad de Caracas and AES Eletropaulo
· Share-based compensation, including stock option and restricted stock unit awards
· Income tax expense

Note the near-obligatory mantra: “All errors that have been presently identified result in non-cash adjustments.” That doesn’t mean they won’t matter: it’ll be interesting to see how widely the revised earnings vary from the original. And it’s interesting to note that the errors were uncovered during the remediation of control weaknesses noted in the 2005 audit. The “Controls” part of last year’s filing listed an amazing number of flaws, and you can see how it took over a year to work them all out. The late filing for 2006 and revocation of the prior years’ financial are just more evidence that internal controls matter… to companies of all sizes.

Many of these errors were identified as a result of the Company’s continuing remediation of previously identified material weaknesses. Other errors were discovered during the Company’s quarterly and year end accounting reviews. All errors that have been presently identified result in non-cash adjustments.”

http://www.accountingobserver.com/blog/

General Non-Communication

From AAO Weblog

Another SAB 108 adjustment regarding interest capitalization pops up in the 10-K filing of General Communication Inc. (The other one noted recently was in the 10-K filing of Deltic Lumber.) Like the Deltic Lumber correction, this one had a favorable effect on retained earnings.

Check this explanation:

“Prior to January 1, 2006, only the interest costs incurred during the construction period of significant capital projects, such as construction of an undersea fiber optic cable system, were capitalized. Beginning January 1, 2006, we modified our interest capitalization policy resulting in the capitalization of material interest costs incurred during the construction period of non-software capital projects and the capitalization of interest costs incurred during the development period of a software capital project.

These misstatements accumulated over several years and were immaterial when quantifying the misstatements using the statement of operations method. Upon adoption of SAB No. 108 on January 1, 2006, we recorded a $3.5 million increase to property and equipment in service and $1.6 million increase to accumulated depreciation for the cumulative misstatement as of December 31, 2005. Accordingly, we increased retained earnings by $1.1 million and recorded $772,000 as a long-term deferred tax liability.”

It’s a pretty minor amount - less than 1% of beginning retained earnings, and the adjustment to PP&E is less than 1%, too. It sounds as if the firm made a policy change as of 1/1/2006, then looked back to see what the effect would have been had the proper policy been in place all the time. It’s not clear that they were examining the differences between policies all along up until the time they changed it. And when they did, the change still didn’t come up to a material amount.

General Communication appears to have defaulted to the retained earnings adjustment approach - something that seems pretty common. But check this excerpt from SAB 108:

“The staff will not object if a registrant does not restate financial statements for fiscal years ending on or before November 15, 2006, if management properly applied its previous approach, either iron curtain or rollover, so long as all relevant qualitative factors were considered.”

If a firm was quantifying its errors all along and waiving them, and application of SAB 108’s dual approach results in a correction, then the retained earnings adjustment is just fine. But if a firm makes a correction to its policy in 2006 and hadn’t been quantifying it all along prior to that change, it could be argued that the retained earnings adjustment is not the right way to go. But it seems like pretty much all companies have taken the retained earnings route, ignoring the fact that restatement is preferable and that immaterial items should simply pass through earnings.

http://www.accountingobserver.com/blog/

Lessons From A Floundering Giant

From AAO Weblog

Time for a break from the drone of SAB 108 adjustments…

I’ll drone instead about the internal controls report in the General Motors 10-K filed last week. The media has jumped on this one because of the sensationalism of the disclosures: the lack of controls over internal reporting and the government investigation of GM’s accounting actually made it into the “Risk Factors” section of the 10-K. Maybe you’d expect that from a start-up - but not from a storied company the size of GM.

Go to section 9A, “Controls and Procedures,” and you’ll see the whole management report on the internal controls. A couple bars go like this:

“1. The Corporation lacked the technical expertise and processes to ensure compliance with SFAS No. 109, Accounting for Income Taxes, and did not maintain adequate controls with respect to (a) timely tax account reconciliations and analyses, (b) coordination and communication between Corporate Accounting and Tax Staffs, and (c) timely review and analysis of corporate journals recorded in the consolidation process…

2. The Corporation in certain instances lacked the technical expertise and did not maintain adequate procedures to ensure that the accounting for derivative financial instruments under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, was appropriate. Procedures relating to hedging transactions in certain instances did not operate effectively to (a) properly evaluate hedge accounting treatment (b) meet the documentation requirements of SFAS No. 133, (c) adequately assess and measure hedge effectiveness on a quarterly basis, and (d) establish the appropriate communication and coordination between relevant GM departments involved in complex financial transactions…

3. The Corporation did not maintain a sufficient complement of personnel with an appropriate level of technical accounting knowledge, experience, and training in the application of generally accepted accounting principles commensurate with the Corporation’s complex financial accounting and reporting requirements and low materiality thresholds…

4. Due to the previously reported material weaknesses, as evidenced by the significant number and magnitude of out-of-period adjustments identified during the year-end closing process and the resulting restatements related to deferred taxes and hedging activities, management has concluded that the controls over the period-end financial reporting process were not operating effectively. Specifically, controls were not effective to ensure that significant non-routine transactions, accounting estimates, and other adjustments were appropriately reviewed, analyzed, and monitored on a timely basis…”

A handful of observations:

• Anyone still in college and reading this blog, take note (all three of you): General Motors doesn’t seem to have a lot of technical expertise on hand when it comes to complex accounting matters. The first three weaknesses discussed above all had a common thread - a lack of technically competent personnel. It’s not just in Detroit, folks. This is one of the most common weaknesses you can observe if you spend time reading these control reports. That’s a great thing for people looking for a career in accounting.

(Of course, finance is sexier and sounds cooler to the opposite sex than accounting, especially in your college years. Who needs accountants? Why, the world simply cries out for more investment bankers! Sober up, finance students. If you really want to go where your talents are needed, and the future looks bright, think about accounting.)

• Don’t blame GM’s problems on “complexity.” General Motors is a great big consenting adult of a corporation. It engages in business in many taxing locales, and it voluntarily chose to use derivatives. If you’re going to do things that involve complex transactions that are hard to communicate to your shareholders, be prepared to account for them the right way.

• Underinvestment in accounting and finance staff saves dollars in the short run - but costs the firm’s reputation dearly in the long run. In this regard, General Motors is no different than so many other companies who’ve come up short in the controls-over-reporting department. Financial reporting is a cost center, for crying out loud: the natural managerial instinct is to starve it. Managers do not lay awake at night worrying about the configuration of accounting and finance departments the same way they’d fret over the layout of the marketing function or the advertising budget. Those functions make money for the company whereas accounting and finance are often viewed as a drain - until it’s time to do the work over again (see “Restatement Zoo” link at right). Then the new accounting and finance people are pretty important. For a while.

• Corollary and conclusion: it’s a management problem. But it’s so much easier to just blame accounting for being too demanding. Again, this is not to single out GM as particularly inept. It’s just that it happens to be one of our country’s biggest firms and employers, and this scenario has played out in so many other instances over the past few years. This is a sprawling giant of a company, a management challenge all its own in every department. It’s apparent from these weaknesses that insufficient managerial attention was given to managing the accounting and finance function.

General Motors has taken some big strides towards pulling its finance staff out of the muck and onto the track; it discusses them in Section 9 as well.

It would be great to see other companies face up to their underinvestment in controls and accounting personnel. After all - what’s good for GM is good for the United States too.

http://www.accountingobserver.com/blog/

Chairman Cox: Supporting SOX 404

From AAO Weblog

Yesterday, SEC Chairman Christopher Cox spoke before the U.S. Chamber of Commerce’s First Annual Capital Markets Summit, and delivered surprising support for the Sarbanes-Oxley Act.

Cox’s appearance was well-timed given that the Chamber just last week had issued its report and recommendations on “Regulation of U.S. Capital Markets in the 21st Century.” That report was critical of Section 404 and the SEC’s oversight.

Said Chairman Cox:

“Yours is not the first, nor will it be the last, outside group to tell us that there are significant direct and indirect costs that come along with the benefits of Sarbanes-Oxley. The SEC’s own analyses of Section 404 of Sarbanes-Oxley are in general agreement with what the Government Accountability Office, the Schumer-Bloomberg report, the Hubbard-Thornton report from the Committee on Capital Markets Regulation, and your own Commission have found: that while a portion of the first-year compliance experience of Sarbanes-Oxley undoubtedly reflected start-up costs — and, in many cases, long-neglected maintenance by companies of their internal control systems and procedures — it is undeniable that much of the cost was attributable to excessive, duplicative, or misdirected efforts.

As your report noted, we’re working to eliminate the unnecessary costs of 404 compliance. We are serious about it, and so is the PCAOB.

That said, it is wrong to conflate the implementation problems of 404 with the entirety of the Sarbanes-Oxley Act. While it’s a handy whipping boy, overall the law has had important positive effects. It may fairly be credited with correcting the most serious problems that beset our markets just a few years ago. It has played a significant and valuable role in restoring integrity to our markets. Remember where we were, and what happened. We needed decisive action. Sarbanes-Oxley delivered.”

Spirited stuff, and he got it right. Worth checking out the whole speech here.

http://www.accountingobserver.com/blog/

Bowater: Yet Another Favorable 108 Correction

FRom AAO Weblog

Bowater, the newsprint producer, corrected a collection of previously-considered immaterial errors it was carrying on its balance sheet, noted in its 10-K filing. As has been noted in other recent posts - the correction resulted in an increase to retained earnings.

(I’ve been noting these things as I find them; I’m not looking for just favorable adjustments. And I’m at a loss to explain the string of positive adjustments resulting from the application of SAB 108. For now, I’m chalking it up to mere coincidence.)

Reasons for the retained earnings adjustment: incorrect vacation liability accruals dating back to the 1980’s. (Van Halen was inducted into the Rock & Roll Hall of Fame this week - and these mistakes being fixed just now are as old as the band!) Deferred tax slip-ups. And incorrect accounting for purchased materials.

All in all, an adjustment of only about $9 million to beginning retained earnings. Notable for the direction of correction, not the amount.

http://www.accountingobserver.com/blog/

GATX: Another Favorable 108 Correction

From AAO Weblog

GATX Corporation, the financial and leasing outfit, made a SAB 108 “cumulative adjustment” type of correction to its beginning 2006 retained earnings, noted in its 10-K filing.

This one (like the Deltic Timber adjustment noted yesterday) has a favorable flavor to it: the correction, after applying both rollover and iron curtain evaluation, increased the beginning balance of retained earnings by almost 3%.

Reason? Before 2002, the company had sold multiple segments which it had reported as discontinued operations, and accrued for post-retirement employment benefits on an undiscounted basis for severed employees and retirees of the sold business. GATX retained responsibility for the liability. Subsequently, erroneously-calculated expenses for post-retirement employment benefits of the former employees in those sold businesses were charged against the accruals. GATX had previously waived them as immaterial, but the dual approach of SAB 108 resulted in their classification as material. Thus, $19.2 million was added back to opening retained earnings as of January 1, 2006.

The finer filter of SAB 108 strikes again.

http://www.accountingobserver.com/blog/

Deltic Timber: A Happy SAB 108 Adjustment

From AAO Weblog

When you think of SAB 108 adjustments, you naturally expect a cut to retained earnings. But not all of the SAB 108 catch-up adjustments carry a sting.

Take Deltic Timber, for instance. The lumber company’s 10-K showed that the firm boosted its retained earnings by $1,767,000 at January 1, 2006. It had not properly capitalized interest incurred on all of its real estate projects, and used the occasion to bring investment in real estate and deferred taxes up to snuff at the same time. In Deltic’s case, those adjustments were material.

On the other hand, it also used the occasion for a general balance sheet housecleaning and cleaned up its incorrect amortization policy for deferred charges and incorrect accrual of liabilities. Those corrections were not material - but they were run through retained earnings anyway.

No harm done - but SAB 108 is really for the errors that now appear to be material under either of the methods of error evaluation - rollover or iron curtain. Immaterial errors really belong in earnings, not tossed into the SAB 108 stew.

http://www.accountingobserver.com/blog/

How Long Can XM and Sirius Survive on Their Own?

A crucial point may be getting lost in the shuffle in the XM/Sirius (XMSR-SIRI) merger approval process.  Both of these companies NEED the merger in order to survive as they stand today.  We took a look at the current cash burn rates for both companies to see how long they could survive on their own, which could become a big factor as merger proceedings drag on for months and months.  The companies do not expect all of the conditions and integrations to come until later in the year as it stands now, and there has already been the notation that new subscribers will slow until the outcome is clear.  This originally started out merely as a "how long until zero for each" scenario, but upon further review some obvious changes are showing themselves.

Sirius has shown higher growth rates but it also has much higher acquisition costs per subscriber: our forecast is $95 to $105 per subscriber for Sirius compared to $64 per subscriber at XM for 2007.  Total estimated operating expenses for 2007 are roughly equivalent at the two companies, and based on our subscriber estimates the monthly revenue and cash burn rates are as follows:

XMSR: Revenue $83 million/month; Operating Expense $129.8 million/month;
Current Cash Balance (including lease-back proceeds) $506,550,000
Estimated months of operation under current conditions – 10.8 months

SIRI: Revenue $75 million/month; Operating Expense $123 million/month;
Cash Balance (as of 12/31/06) $408,000,000
Estimated months of operation – 8.4 months

XMSR has recently opened a new door that probably gives them the best source of cheap capital available to them by negotiating a sale-leaseback on their most recently-launched XM4 satellite, bringing in over $280 million in proceeds.  Both XM Satellite and Sirius have 4 satellites in operation currently, but the XM4 was the newest and is therefore considerably more valuable than the other 7 in orbit.  But both companies can access cash in this manner if they choose to do so.  How much so we can’t say, but at least a benchmark level has been set that could prove vital in keeping these companies afloat in the face of disastrously-expensive debt financings or even more utterly-dilutive stock offerings.  It may even be arguable that these companies are now in a situation where the capital markets are partially closed to them.

There are some obvious issues here that can make or break any of these figures and circumstances.  S&P recently defended Sirius, sort of.  We openly admit that the companies could also curb certain expenses and renegotiate pacts to slow this cash-burn down; and there are credit facilities that can still be accessed.  While we have said the capital markets may be closed off, betting that there would be NO lenders, no financiers, no satellite equity ventures is probably silly.  Someone somewhere would give either or both of these companies money or access to credit, but they would want to do so after the merger approval decisions are a known event.  It is very likely that these companies could operate well into 2008 without having to go into voodoo financings.  Jim Cramer thinks this one goes through as well.

But the issue still revolves around the merger and this is what each government oversight group needs to consider: Higher prices now or higher prices later?  They can allow a monopoly in a non-critical entertainment and information industry that would sign in blood for 1-year to 3-year price-lock agreements without question OR they can block the merger and allow one or both to operate at levels where each may fail.  If the powers that be are worried about rising prices if this goes through, then they need to look at the fact that the subscription price will HAVE to rise immediately for each of these to survive independently without a lower combined cost structure.

Evaluating a merger of this proportion should be a comparative no-brainer to other DOJ and FCC mergers that have been approved, and the only reason this is an issue is because of a potential changing of the guard in 2008 (technically a change is coming either way, and the oversight committees are already under new leadership).  We aren't forgetting the old law that prohibits the licenses from being under one company, but the FCC has already indicated this could be changed under the right conditions. If this was a merger of NBC and Clear Channel or something to that extent then it would have obvious objections.  This is nowhere as critical as a merger between AT&T and SBC Communications that was allowed to go through.  Satellite radio is non-critical radio, even if you are addicted to Howard Stern, Martha Stewart, or Oprah.  They both offer some serious packages and are almost without question an addition to their loyal fans and subscribers, but the flow of free information would not be cut off if these 8 satellites suddenly decided to come back into the atmosphere.

Congress, the FCC, and the DOJ need to determine the fate of these soon for the sake of consumers AND for the sake of the companies.  Do they want to "champion competition and the consumer" and force them to remain independent?  Or do they want to pander to business and shareholders?  If they force the companies to remain independent, then subscribers better just go ahead and presume they will face higher subscribers fees starting in 2008.  If Congress, the DOJ and the FCC allow the merger to proceed, then they will be able to assure that consumers get price locks and programming locks until 2010. 

It is very surprising that this is not brought up for discussion, and management should take this to task by saying that if they are independent that the only way they can survive is by price hikes.  It may only pertain to NEW subscribers, but prices would have to rise for both to remain independent.  As it stands right now, both companies could find themselves in a precarious spot toward the end of 2007.  If these are allowed to merge then there will probably be some easy access to capital and the combined cost structures will be much more efficient.

Late in 2006 we also evaluated how a combined company would look, so this is not the first ponderance of this sort.  The way the media and government cover things, you can probably assume it won't be the last either.

Written by Jon C. Ogg & by Ryan Barnes
March 11, 2007

Jon Ogg can be reached at jonogg@247wallst.com; he does not own securities in the companies he covers.

CSGS: CSG Tax Disclosure Confusing

By William Trent, CFA of Stock Market Beat

Small Cap Watch List member CSG Systems (CSGS) issued its 10K last week. We haven’t had a chance to review it thoroughly, but did notice some comments from Jack Ciesielski at the Analysts Accounting Observer Weblog.

First, this mention of SAB 108 in Note 3: “During the fourth quarter of 2006, we adopted SEC Staff Accounting Bulletin No. 108, “Considering the Effects of Prior year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”)… Our adoption of SAB 108 did not have any impact to our consolidated financial statements.”

But that bland statement of business-as-usual is contradicted by this one in the MD&A:

Income Tax Provision. The following are the key changes related to our income tax provision from continuing operations between years:

• For 2006, we recorded an income tax provision of $38.4 million, or an effective income tax rate of approximately 38%…
For the fourth quarter of 2006, we recorded an effective income tax rate of approximately 42%. The higher effective income tax rate was primarily the result of a correction of minor income tax expense items from previous periods that were not considered material to the current or past periods, giving consideration to the SEC’s Staff Accounting Bulletin No. 108, and thus were recorded in their entirety in the fourth quarter….
Hello? The effective tax rate was higher for the fourth quarter by 4% because of an adjustment for the SAB 108 correction of tax items - but simultaneously, the “adoption of SAB 108 did not have any impact to our consolidated financial statements?”

Which premise is correct? Not both.

CSG Systems: They Mumbled Something Sounding Like “SAB 108″

From AAO Weblog

CSG Systems filed their 10-K last week, and mentioned the effect of SAB 108 on their financials. But it’s a bit hard to piece together what they meant.

First, this mention of SAB 108 in Note 3: “During the fourth quarter of 2006, we adopted SEC Staff Accounting Bulletin No. 108, “Considering the Effects of Prior year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”)… Our adoption of SAB 108 did not have any impact to our consolidated financial statements.”

All well and good. And pretty consistent with the majority of companies noticed so far: no impact from the adoption of SAB 108. Not everyone had errors worth correcting under either the rollover or iron curtain approach required by SAB 108, it seems.

But that bland statement of business-as-usual is contradicted by this one in the MD&A:

Income Tax Provision. The following are the key changes related to our income tax provision from continuing operations between years:

• For 2006, we recorded an income tax provision of $38.4 million, or an effective income tax rate of approximately 38%, compared to an income tax provision of $26.2 million, or an effective income tax rate of approximately 36% in 2005 …

For the fourth quarter of 2006, we recorded an effective income tax rate of approximately 42%. The higher effective income tax rate was primarily the result of a correction of minor income tax expense items from previous periods that were not considered material to the current or past periods, giving consideration to the SEC’s Staff Accounting Bulletin No. 108, and thus were recorded in their entirety in the fourth quarter. The accounting correction of these items is considered one-time in nature, and is not expected to materially impact our estimated income tax rate going forward.

Hello? The effective tax rate was higher for the fourth quarter by 4% because of an adjustment for the SAB 108 correction of tax items - but simultaneously, the “adoption of SAB 108 did not have any impact to our consolidated financial statements?”

Which premise is correct? Not both.

Give them credit for taking the high road and not revising history through retained earnings - they’re one of the rare companies observed so far who have taken the SAB 108 corrections into earnings. On the other hand, there’s no other visibility into the nature of the errors: there are no other descriptions, even in the tax note. And no good explanation; all investors can do is take it at face value that the errors were minor. Typical corporate shyness when it comes to disclosures about taxes, one supposes.

http://www.accountingobserver.com/blog/

Take-Two's Board Gunned Down By Shareholders

Take-Two Interactive (TTWO) is seeing a strange issue today because of a Schedule 13D filing with the SEC on behalf of shareholders.  A group of shareholders have banded together and are going to basically kick the board of directors out of the company.  This strategy goes beyond activist investing because it is essentially a seizure of control without a buyout. 

This group in the filing includes OppenheimerFunds, SAC Capital Management (Cohen), Tudor Investment (Jones), D.E. Shaw, and ZelnickMedia have created a group with more than a 24% stake in Take-Two.  The group plans to vote for a panel of new directors, will ask for the right to replace the CEO and will review the CFO position.  It is unknown if there are others that will try to band up with the group, but that may be a safe assumption.

The group is going to appoint ZelnickMedia as the financial and management consultant.  Here is ZelnickMedia's fee structure: $62.500.00 per month, annual bonus of up to $750,000.00 and an option to buy up to 2.5% of the fully diluted shares over a 3-year period, plus reasonable reimbursement for expenses.  There are more refined details in the filing, but these turnaround issues could be a rough blueprint for other activist and seizure types of investments.

This is one day after the controversial Grand Theft Auto: Vice City Stories franchise game was made available for PS2 consoles in North America.  It appears that the only remaining issue will be if the investor group offers some hot coffee to the board.

Shares are up roughly 11% at $19.60 on the day and it has already seen more than an average daily volume.  The 52-week trading range is $9.06 to $21.06, so shares have virtually doubled since the absolute lows from its video game recalls, fines, government inquiries, stock options issues, and ousting of leadership.  TTWO used to be a $25.00 and higher stock before all of its issues started biting the company back.

Jon C. Ogg
March 7, 2007

Jon Ogg can be reached at jonogg@247wallst.com; he does not own securities in the companies he covers.

Alaska Air: Lease Restatements Deja Vu

From AAO Weblog

Remember the wave of lease restatements from early 2005? That was when a letter from then-chief accountant Don Nicolaisen triggered re-examinations of lease contracts and accounting far and wide, resulting in over 200 corrections and restatements.

Alaska Airlines wasn’t one of the companies with a problem, however. Until now. In its 2006 10-K filing, the company performed a SAB 108 adjustment to its beginning of year 2006 retained earnings for $6 million. The adjustment was related to improper amortization of leasehold improvements. How so? Borrowing from the filing, “[o]ur airport lease agreements do not generally carry a renewal right in them, which is a key consideration for SFAS 13 “lease term” definitions.” That key consideration is that a firm shouldn’t depreciate equipment or amortize leasehold improvements for a longer period than it has the right to use the property to which they are attached.

Which is exactly what the airline was doing. Small potatoes, each year, according to the company. To catch up the correction, however, would have been material to earnings in a given period - so the company must have been relying on the balance sheet “iron curtain” approach to determining materiality.

And the same approach must have been used with the “market subsidy” paid to the Horizon commuter lines unit. The company purchased aircraft and received payments from the manufacturer, which the company recognized in income on a cash basis for 7 to 8 years, depending on the kind of aircraft. It would have been more correct to match the recognition of the credit with the lives of aircraft involved - a 15 to 17 year stretch. That immaterial difference tacked $12.6 million onto earnings for the periods affected - a total of $18.6 million for the two kinds of errors. Curiously - no mention of the periods covered, so investors can see just how material the amounts might have been to discrete periods. It’s not a SAB 108 requirement, but it would have been a braver voluntary disclosure.

http://www.accountingobserver.com/blog/

Albany International: SAB 108 In Benefits Plans

From AAO Weblog

Albany International, the paper manufacturing equipment maker, published its 10-K last Thursday, and revealed a Staff Accounting Bulletin No. 108 adjustment that was unique in that it affected the firm’s pension and other postemployment benefit reporting; haven’t seen many of those yet.

It turns out that the postretirement benefit obligation had been underaccrued by $2.1 million; the net adjustment to bring it up to snuff was for $1.47 million, or $.05 per basic share. According to the benefit plan footnotes, “[t]he underaccrual was related to cash payments made by the Company during in 2004 and 2005 for retiree medical and life insurance benefits,” making it sound like there were payments made for something in those years that were incorrectly classified as for medical and life insurance benefits. It’s hard to figure out what other way there could have been an underaccrual related to cash payments. The filing is rather short on details.

Another interesting aspect of the correction: these errors occurred in 2004 and 2005. Call them old. They were discovered in 2006 and evaluated in accordance with SAB 108. In that they were old errors, they were perfect candidates for the “beginning retained earnings catch-up” treatment available under SAB 108 - but the company ran the adjustment through earnings in operating expenses. Maybe they just decided to take the high road. And maybe I just haven’t seen enough annuals yet, but that’s the first in-earnings SAB 108 adjustment I’ve come across.

http://www.accountingobserver.com/blog/

The 2006 Restatement Tally

From AAO Weblog

Great article by Steven Taub at CFO.com on Glass Lewis’ annual study on restatements. Link here.

Key points: in the aggregate for 2006, restatements are up - way up. According to the article, “1,244 U.S. companies and 112 foreign companies—filed 1,538 financial restatements to correct errors represent 9.8 percent of all U.S. public companies. In 2005, only one in 12 companies restated their financial results.”

But that’s not the whole story. Chop up the data among the market caps of the companies doing the restating, and you get some insight into the effectiveness of Sarbanes-Oxley Section 404 reviews. Among the companies that had been evaluating their internal control systems and having auditor opinions expressed on them, the number of restatements fell by 14%. Hard to call that mere coincidence, one would think.

Likewise, it would be hard to call mere coincidence the rise in restatements among companies who didn’t have internal control reviews. Restatements among the small fry - the very same ones who resist internal control evaluation and attestation - rose 40%.

Along the lines of the ancient philosophical question, “If a tree falls in a forest and nobody is there, does it make a sound?” consider this one: “Is a law really a law if it never goes into effect?”

Or maybe: “If a company’s investors are left holding the bag because the company’s misreporting to them could have been prevented by compliance with a law they passed - do politicians care?”

I guess the answer to that one is, it depends on who’s voting.

http://www.accountingobserver.com/blog/

WestAmerica: Man Bites Dog

From AAO Weblog

Make that “stock comp error correction treats shareholders well.” Ah, no. More descriptive, but lacks punch.

WestAmerica Bancorporation filed its 10-K yesterday, and revealed a SAB 108 correction for the overaccrual of liabilities related to employee stock-based compensation.

It was a minor amount - $3 million pretax, $1.8 million aftertax - especially when compared to stockholders’ equity of $424 million. The interesting thing is that it was a reduction of other liabilities for the compensation, and an increase to stockholders’ equity.

When you think of error corrections involving stock compensation, you have a tendency to think in the reverse direction. Truly a case of “man bites dog.”

http://www.accountingobserver.com/blog/

SAB 108: K-Swiss Cleans House

From AAO Weblog

In its 10-K filed last Thursday, sneaker maker K-Swiss presented its clean-up adjustment of payroll withholding taxes:

“In 2006, we determined that there was an underpayment of payroll withholdings in a foreign jurisdiction from January 1, 1993 through December 31, 2006. With the assistance of our tax advisors, we estimated underpayment of withholdings of approximately $5,131,000 and related interest of approximately $5,974,000, totaling $11,105,000.”

All told, the company adjusted its retained earnings balance for a net amount of $7.9 million - which would be a pretty sizable chunk of its $76.9 million in 2006 earnings. That is, a sizable chunk, if Staff Accounting 108 didn’t give companies the chance to catch up adjustments through retained earnings. Instead of making such housecleanings visible through a charge on the income statement, SAB 108 forces investors to look through the notes or the equity section of the balance sheet to find them.

Yes, those amounts didn’t all relate to 2006, as defenders of the approach might say. Then again, they didn’t relate to activity for 2006 in retained earnings, either. When you’ve got charges relating to the wrong periods, it’s best to restate in order to present the best picture of what really happened in the company. If the SEC isn’t going to require firms to do that, at least they should have required them to make the cleanup visible in the income statement - something to point investors to the discussion