Question
Do you really understand the SEC's Rule 144a?
What is it and why do accountants hate it?

 

That America's public capital markets have lost some of their allure is no longer much disputed. Eminences as unlikely as Chuck Schumer and Eliot Spitzer have taken to bemoaning the fact and calling for some sort of fix, albeit without doing much.

Tort reform -- to reduce jackpot justice in securities class-action suits -- would certainly help. So would easing the compliance costs and regulatory burden placed on publicly traded companies by Sarbanes-Oxley, Regulation FD and the like. (See Robert Grady nearby.) The good news is that, as usual, private-sector innovation is finding a way around these government obstacles through the rapid growth of something known as the Rule 144a market.

First, a little capital-markets background: Most Americans are familiar with the "public markets," which consist of the New York Stock Exchange, the Nasdaq and other stock markets. These are open to investors of every stripe and are where the stocks of most of the world's best-known companies are traded. Nearly anyone can invest, and these exchanges are comprehensively regulated by the Securities and Exchange Commission.

Less well understood is another, more restricted market known after SEC Rule 144a that governs participation in it. As on stock exchanges, this market allows for the buying and selling of the stock of companies that offer their shares for sale. But participation is strictly limited. To be what is called a "qualified buyer" in this market, you must be a financial institution with at least $100 million in investable assets. If you meet these criteria, you are free to buy stocks of both U.S. and foreign companies that have never offered their shares to the investing public.

And here's the real beauty of it: Companies that issue stock under Rule 144a can access America's deep pools of capital without submitting to public-company accounting rules or to the tender mercies of Sarbanes-Oxley. In exchange, however, they must strictly limit the number of qualified U.S. investors in their company -- to 500 total for U.S.-based firms and 300 for foreign-based. They are also barred from offering comparable securities for sale in the public market. The 144a market is also for the most part nontransparent, often illiquid and thus in some ways riskier. But increasingly, this is a trade that institutional investors and companies seeking capital are willing to make.

There are estimated to be about 1,000 companies whose stocks trade in the 144a market. And last year, for perhaps the first time, more capital was raised in the U.S. by issuing these so-called unregistered securities than through IPOs on all the major stock exchanges combined. Even more telling is that the large institutional investors eligible to buy these unregistered securities are more than happy to oblige. There is no selling without buying, and for the 144a market to overtake the giant stock exchanges, institutional investors who control trillions of dollars in capital must see better opportunities outside the regulations built by Congress and the SEC.

In a sign of these times, none other than Nasdaq is now stepping in to bring some greater order, liquidity and transparency to the Rule 144a market. Any day now, the SEC is expected to propose giving the green light to a Nasdaq project called Portal. Portal aims to be a central clearing house for buyers and sellers of Section 144a securities. You will still need to be a "qualified institutional buyer" to purchase 144a securities. And the companies whose stocks change hands on Portal will still need to meet the limitations on numbers of investors to offer their stock there.

So Portal will not bring unregistered securities to the masses -- at least not directly. It is forbidden to do so because the entire U.S. regulatory system is designed to protect individual investors from such things. What Portal will do, if it operates as intended, is make the trading of Rule 144a securities easier and less costly. And this could, in turn, further increase their attractiveness to issuers and investors alike. Average investors will at least be able to participate indirectly via mutual and pension funds, most of which meet the standards for "qualified institutional buyers."

Given the limitations on eligibility for Rule 144a assets, they will never replace our public markets. But their growth is one more sign that investors, far from valuing current regulation, are seeking ways to avoid its costs and complications. Nasdaq's participation is especially notable given its stake as an established public exchange. Nasdaq seems to have concluded that there is a new market opportunity created by overregulation, so it is following the money.

This leaves our politicians with two choices. They can move to meddle with and diminish this second securities market -- which will only drive more business away from U.S. shores. Or they can address the overregulation that is hurting public markets and prompting both investors and companies to seek alternatives.

Hi Dean,

Thank you for the kind words.

Hedge fund shorts are often used in expectations to re-buy. You might take a look at the following:
"Subprime crisis: the lay-out of a puzzle: An empirical investigation into the worldwide financial consequences of the U.S. subprime crisis" ---
http://oaithesis.eur.nl/ir/repub/asset/5163/0509ma281597wm.pdf

 

Money for Nothing How CEOs and Boards Enrich Themselves While Bankrupting America
by John Gillespie and David Zweig
Simon and Schuster
http://books.simonandschuster.ca/Money-for-Nothing/John-Gillespie/9781416559931/excerpt_with_id/13802

All eyes are on the CEO, who has gone without sleep for several days while desperately scrambling to pull a rabbit out of an empty hat. Staffers, lawyers, advisors, accountants, and consultants scurry around the company headquarters with news and rumors: the stock price fell 20 percent in the last hour, another of the private equity firms considering a bid has pulled out, stock traders are passing on obscene jokes about the company's impending death, the sovereign wealth fund that agreed to put in $1 billion last fall is screaming at the CFO, hedge fund shorts are whispering that the commercial paper dealers won't renew the debt tomorrow, the Treasury and the Fed aren't returning the CEO's calls about bailout money, six satellite trucks—no, seven now—are parked in front of the building, and reporters with camera crews are ambushing any passing employee for sound bites about the prospects of losing their jobs.

Chaos.

In the midst of this, the board of directors—the supposedly well-informed, responsible, experienced, accountable group of leaders elected by the shareholders, who are legally and ethically required to protect the thousands of people who own the company—are . . . where? You would expect to them to be at the center of the action, but they are merely spectators with great seats. Some huddle together over a computer screen in a corner of the boardroom, watching cable news feeds and stock market reports that amplify the company's death rattles around the world; others sit beside a speakerphone, giving updates to board colleagues who couldn't make it in person. Meetings are scheduled, canceled, and rescheduled as the directors wait, hoping for good news but anticipating the worst.

The atmosphere is a little like that of a family waiting room outside an intensive care unit—a quiet, intense churning of dread and resignation. There will be some reminiscing about how well things seemed to be going not so long ago, some private recriminations about questions never asked or risks poorly understood, a general feeling of helplessness, a touch of anger at the senior executives for letting it come to this, and anticipation of the embarrassment they'll feel when people whisper about them at the club. Surprisingly, though, there's not a lot of fear. Few of the directors are likely to have a significant part of their wealth tied up in the company; legal precedents and insurance policies insulate them from personal liability. Between 1980 and 2006, there were only thirteen cases in which outside directors—almost all, other than Enron and WorldCom, for tiny companies—had to settle shareholder lawsuits with their own money. (Ten of the Enron outside directors who settled—without admitting wrongdoing—paid only 10 percent of their prior net gains from selling Enron stock; eight other directors paid nothing. A number of them have remained on other boards.) More significant, the CEO who over shadowed the board will hardly hurt at all, and will probably leave with the tens or even hundreds of millions of dollars that the directors guaranteed in an employment contract.

So they sit and wait—the board of directors of this giant company, who were charged with steering it along the road to profit and prosperity. In the middle of the biggest crisis in the life of the company, they are essentially backseat passengers. The controls, which they never truly used, are of no help as the company hurtles over a cliff, taking with it the directors' reputations and the shareholders' money. What they are waiting for is the dull thud signaling the end: a final meeting with the lawyers and investment bankers, and at last, the formality of signing the corporate death certificate—a bankruptcy filing, a forced sale for cents on the dollar, or a government takeover that wipes out the shareholders. The CEO and the lawyers, as usual, will tell the directors what they must do.

THIS IS NOT JUST A GLOOMY, hypothetical fable about how an American business might possibly fail, with investors unprotected, company value squandered, and the governance of enormous and important companies breaking down. This is, unfortunately, a real scenario that has been repeated time and again during the recent economic meltdown, as companies have exploded like a string of one-inch firecrackers. When the spark runs up the spine of the tangled, interconnected fuses, they blow up one by one.

Something is wrong here. As Warren Buffett observed in his 2008 letter to Berkshire Hathaway shareholders, "You only learn who has been swimming naked when the tide goes out—and what we are witnessing at some of our largest financial institutions is an ugly sight."

Just look at some of the uglier sights. Merrill Lynch, General Motors, and Lehman Brothers, three stalwart American companies, are only a few examples of corporate collapses in which shareholders were burned. The sleepy complicity and carelessness of their boards have been especially devastating. Yet almost all the public attention has focused on the greed or recklessness or incompetence of the CEOs rather than the negligence of the directors who were supposed to protect the shareholders and who ought to be held equally, if not more, accountable because the CEOs theoretically work for them.

Why have boards of directors escaped blame? Probably because boards are opaque entities to most people, even to many corporate executives and institutional investors. Individual shareholders, who might have small positions in a number of companies, know very little about who these board members are and what they are supposed to be doing. Their names appear on the generic, straight-to-the-wastebasket proxy forms that shareholders receive; beyond that, they're ciphers. Directors rarely talk in public, maintaining a code of silence and confidentiality; communications with shareholders and journalists are invariably delegated to corporate PR or investor relations departments. They are protected by a vast array of lawyers, auditors, investment bankers, and other professional services gatekeepers who keep them out of trouble for a price. At most, shareholders might catch a glimpse of the nonexecutive board members if they bother to attend the annual meeting. Boards work behind closed doors, leave few footprints, and maintain an aura of power and prestige symbolized by the grand and imposing boardrooms found in most large companies. Much of this lack of transparency is deliberate because it reduces accountability and permits a kind of Wizard of Oz "pay no attention to the man behind the curtain" effect. (It is very likely to be a man. Only 15.2 percent of the directors of our five hundred largest companies are women.) The opacity also serves to hide a key problem: despite many directors being intelligent, experienced, well-qualified, and decent people who are tough in other aspects of their professional lives, too many of them become meek, collegial cheerleaders when they enter the boardroom. They fail to represent shareholders' interests because they are beholden to the CEOs who brought them aboard. It's a dangerous arrangement.

On behalf of the shareholders who actually own the company and are risking their money in anticipation of a commensurate return on their investments, boards are elected to monitor, advise, and direct the managers hired to run the company. They have a fiduciary duty to protect the interests of shareholders. Yet, too often, boards have become enabling lapdogs rather than trust-worthy watchdogs and guides.

There are, unfortunately, dozens of cases to choose from to illustrate the seriousness of the situation. Merrill, GM, and Lehman are instructive because they were companies no one could imagine failing, although, in truth, they fostered such dysfunctional and conflicted corporate leadership that their collapses should have been foretold. As you read their obituaries, viewer discretion is advised. You should think of the money paid to the executives and directors, as well as the losses in stock value, not as the company's money, as it is so often portrayed in news accounts, but as your money—because it is, in fact, coming from your mutual funds, your 401(k)s, your insurance premiums, your savings account interest, your mortgage rates, your paychecks, and your costs for goods and services. Also, think of the impact on ordinary people losing their retirement savings, their jobs, their homes, or even just the bank or factory or car dealership in their towns. Then add the trillions of taxpayers' dollars spent to prop up some of the companies' remains and, finally, consider the legacy of debt we're leaving for the next generation.

———

DURING MOST OF HIS nearly six years at the top of Merrill Lynch, Stanley O'Neal simultaneously held the titles of chairman, CEO, and president. He required such a high degree of loyalty that insiders referred to his senior staff as the Taliban. O'Neal had hand-picked eight of the firm's ten outside board members. One of them, John Finnegan, had been a friend of O'Neal's for more than twenty years and had worked with him in the General Motors treasury department; he headed Merrill's compensation committee, which set O'Neal's pay. Another director on the committee was Alberto Cribiore, a private equity executive who had once tried to hire O'Neal.

Executives who worked closely with O'Neal say that he was ruthless in silencing opposition within Merrill and singleminded in seeking to beat Goldman Sachs in its profitability and Lehman Brothers in the risky business of packaging and selling mortgage-backed securities. "The board had absolutely no idea how much of this risky stuff was actually on the books; it multiplied so fast," one O'Neal colleague said. The colleague also noted that the directors, despite having impressive rÉsumÉs, were chosen in part because they had little financial services experience and were kept under tight control. O'Neal "clearly didn't want anybody asking questions."

For a while, the arrangement seemed to work. In a triumphal letter to shareholders in the annual report issued in February 2007, titled "The Real Measure of Success." O'Neal proclaimed 2006 "the most successful year in [the company's] history—financially, operationally and strategically," while pointing out that "a lot of this comes down to leadership." The cocky message ended on a note of pure hubris: "[W]e can and will continue to grow our business, lead this incredible force of global capitalism and validate the tremendous confidence that you, our shareholders, have placed in this organization and each of us."

The board paid O'Neal $48 million in salary and bonuses for 2006—one of the highest compensation packages in corporate America. But only ten months later, after suffering a third-quarter loss of $2.3 billion and an $8.4 billion writedown on failed investments—the largest loss in the company's ninety-three-year history, exceeding the net earnings for all of 2006—the board began to understand the real measure of failure. The directors discovered, seemingly for the first time, just how much risk Merrill had undertaken in becoming the industry leader in subprime mortgage bonds and how overleveraged it had become to achieve its targets. They also caught O'Neal initiating merger talks without their knowledge with Wachovia Bank, a deal that would have resulted in a personal payout of as much as $274 million for O'Neal if he had left after its completion—part of his board-approved employment agreement. During August and September 2007, as Merrill was losing more than $100 million a day, O'Neal managed to play at least twenty rounds of golf and lowered his handicap from 10.2 to 9.1.

Apparently due to sheer embarrassment as the company's failures made headlines, the board finally ousted O'Neal in October but allowed him to "retire" with an exit package worth $161.5 million on top of the $70 million he'd received during his time as CEO and chairman. The board then began a frantic search for a new CEO, because, as one insider confirmed to us, it "had done absolutely no succession planning" and O'Neal had gotten rid of anyone among the 64,000 employees who might have been a credible candidate. For the first time since the company's founding, the board had to look outside for a CEO. In spite of having shown a disregard for shareholders and a distaste for balanced governance, O'Neal was back in a boardroom within three months, this time as a director of Alcoa, serving on the audit committee and charged with overseeing the aluminum company's risk management and financial disclosure.

At the Merrill Lynch annual meeting in April 2008, Ann Reese, the head of the board's audit committee, fielded a question from a shareholder about how the board could have missed the massive risks Merrill was undertaking in the subprime mortgage-backed securities and collateralized debt obligations (CDOs) that had ballooned from $1 billion to $40 billion in exposure for the firm in just eighteen months. Amazingly, since it is almost unheard of for a director of a company to answer questions in public, Reese was willing to talk. This was refreshing and might have provided some insight for shareholders, except that what she said was curiously detached and unabashed. "The CDO position did not come to the board's attention until late in the process," she said, adding that initially the board hadn't been aware that the most troublesome securities were, in fact, backed by mortgages.

Merrill's new CEO and chairman, John Thain, jumped in after Reese, saying that the board shouldn't be criticized based on "20/20 hindsight" even though he had earlier admitted in an interview with the Wall Street Journal that "Merrill had a risk committee. It just didn't function." As it happens, Reese, over a cup of English tea, had helped recruit Thain, who lived near her in Rye, New York. Thain had received a $15 million signing bonus upon joining Merrill and by the time of the shareholders' meeting was just completing the $1.2 million refurnishing of his office suite that was revealed after the company was sold.

Lynn Turner, who served as the SEC's chief accountant from 1998 to 2001 and later as a board member for several large public companies, recalled that he spoke about this period to a friend who was a director at Merrill Lynch in August 2008. "This is a very well-known, intelligent person," Turner said, "and they tell me, 'You know, Lynn, I've gone back through all this stuff and I can't think of one thing I'd have done differently.' My God, I can guarantee you that person wasn't qualified to be a director! They don't press on the issues. They get into the boardroom—and I've been in these boardrooms—and they're all too chummy and no one likes to create confrontation. So they get together five times a year or so, break bread, all have a good conversation for a day and a half, and then go home. How in the hell could you be a director at Merrill Lynch and not know that you had a gargantuan portfolio of toxic assets? If people on the outside could see the problem, then why couldn't the directors?"

The board was so disconnected from the company that when Merrill shareholders met in December 2008 to approve the company's sale to Bank of America after five straight quarterly losses totaling $24 billion and a near-brush with bankruptcy, not a single one of the nine nonexecutive directors even attended the meeting. Finance committee chair and former IRS commissioner Charles Rossotti, reached at home in Virginia by a reporter, wouldn't say why he wasn't there: "I'm just a director, and I think any questions you want to have, you should direct to the company." The board missed an emotional statement by Winthrop Smith, Jr., a former Merrill banker and the son of a company founder. In a speech that used the word shame some fourteen times, he said, "Today is not the result of the subprime mess or synthetic CDOs. They are the symptoms. This is the story of failed leadership and the failure of a board of directors to understand what was happening to this great company, and its failure to take action soon enough . . . Shame on them for not resigning."

When Merrill Lynch first opened its doors in 1914, Charles E. Merrill announced its credo: "I have no fear of failure, provided I use my heart and head, hands and feet—and work like hell." The firm died as an independent company five days short of its ninety-fifth birthday. The Merrill Lynch shareholders, represented by the board, lost more than $60 billion.

AT A JUNE 6, 2000, stockholders annual meeting, General Motors wheeled out its newly appointed CEO, Richard Wagoner, who kicked off the proceedings with an upbeat speech. "I'm pleased to report that the state of the business at General Motors Corporation is strong," he proclaimed. "And as suggested by the baby on the cover of our 1999 annual report, we believe our company's future opportunities are virtually unlimited." Nine years later, the GM baby wasn't feeling so well, as the disastrous labor and health care costs and SUV-heavy product strategy caught up with the company in the midst of skyrocketing gasoline prices and a recession. GM's stock price fell some 95 percent during Wagoner's tenure; the company last earned a profit in 2004 and lost more than $85 billion while he was CEO. Nevertheless, the GM board consistently praised and rewarded Wagoner's performance. In 2003, it elected him to also chair the board, and in 2007—a year the company had lost $38.7 billion—it increased his compensation by 64 percent to $15.7 million.

GM's lead independent director was George M. C. Fisher, who himself presided over major strategic miscues as CEO and chairman at Motorola, where the Iridium satellite phone project he initiated was subsequently written off with a $2.6 billion loss, and later at Kodak, where he was blamed for botching the shift to digital photography. Fisher clearly had little use for shareholders. He once told an interviewer regarding criticism of his tenure at Kodak that "I wish I could get investors to sit down and ask good questions, but some people are just too stupid." More than half the GM board was composed of current or retired CEOs, including Stan O'Neal, who left in 2006, citing time constraints and concerns over potential conflicts with his role at Merrill that had somehow not been an issue during the previous five years.

Upon GM's announcement in August 2008 of another staggering quarterly loss—this time of $15.5 billion—Fisher told a reporter that "Rick has the unified support of the entire board to a person. We are absolutely convinced we have the right team under Rick Wagoner's leadership to get us through these difficult times and to a brighter future." Earlier that year, Fisher had repeatedly endorsed Wagoner's strategy and said that GM's stock price was not a major concern of the board. Given that all thirteen of GM's outside directors together owned less than six one-hundredths of one percent of the company's stock, that perhaps shouldn't have been much of a surprise.

Wagoner relished his carte blanche relationship with GM's directors: "I get good support from the board," he told a reporter. "We say, 'Here's what we're going to do and here's the time frame,' and they say, 'Let us know how it comes out.' They're not making the calls about what to do next. If they do that, they don't need me." What GM's leaders were doing with the shareholders' dwindling money was doubling their bet on gas-guzzling SUVs because they provided GM's highest profit margins at the time. As GM vice chairman Robert Lutz told the New York Times in 2005: "Everybody thinks high gas prices hurt sport utility sales. In fact they don't . . . Rich people don't care."

But what seemed good for GM no longer was good for the country—or for GM's shareholders.

Ironically, GM had been widely praised in the early 1990s for creating a model set of corporate governance reforms in the wake of major strategic blunders and failed leadership that had resulted in unprecedented earnings losses. In 1992, the board fired the CEO, appointed a nonexecutive chairman, and issued twenty-eight structural guidelines for insuring board independence from management and increasing oversight of long-term strategy. BusinessWeek hailed the GM document as a "Magna Carta for Directors" and the company's financial performance improved for a time. The reform initiatives, however, lasted about as long as the tailfin designs on a Cadillac. Within a few years, despite checking most of the good governance structural boxes, the CEO was once again also the board chairman, the directors had backslid fully to a subservient "let us know how it comes out" role, and the executives were back behind the wheel.

In November 2005, when GM's stock price was still in the mid-20s, Ric Marshall, the chief analyst of the Corporate Library, a governance rating service that focuses on board culture and CEO-board dynamics, wrote: "Despite its compliance with most of the best practices believed to comprise 'good governance,' the current General Motors board epitomizes the sad truth that compliance alone has very little to do with actual board effectiveness. The GM board has failed repeatedly to address the key strategic questions facing this onetime industrial giant, exposing the firm not only to a number of legal and regulatory worries but the very real threat of outright business failure. Is GM, like Chrysler some years ago, simply too big to fail? We're not sure, but it seems increasingly likely that GM shareholders will soon find out."

By the time Wagoner was fired in March 2009, at the instigation of the federal officials overseeing the massive bailout of the company, the stock had dropped to the $2 range and GM had already run through $13.4 billion in taxpayers' money. In spite of this, some directors still couldn't wean themselves from Wagoner, and were reportedly furious that his dismissal occurred without their consent. Others were mortified by what had happened to the company. One prominent director, who had diligently tried to help the company change course before it was too late, had eventually quit the board out of frustration with the "ridiculous bureaucracy and a thumb-sucking board that led to GM making cars that no one wanted to buy." Another director who left the board recalled asking Wagoner and his executive team in 2006 for a five-year plan and projections. "They said they didn't have that. And most of the guys in the room didn't seem to care."

The GM shareholders, represented by the board, lost more than $52 billion.

IN A COMPANY as large and complex as Lehman Brothers, you would expect the board to be seasoned, astute, dynamic, and up-to-date on risks it was undertaking with the shareholders' money. Yet the only nonexecutive director, out of ten, with any recent banking experience was Jerry Grundhofer, the retired head of U.S. Bancorp, who had joined the board exactly five months before Lehman's spectacular collapse into bankruptcy. Nine of the independent directors were retired, including five who were in their seventies and eighties. Their backgrounds hardly seemed suited to overseeing a sophisticated and complicated financial entity: the members included a theatrical producer, the former CEO of a Spanish-language television company, a retired art-auction company executive, a retired CEO of Halliburton, a former rear admiral who had headed the Girl Scouts and served on the board of Weight Watchers International, and, until two years before Lehman's downfall, the eighty-three-year-old actress and socialite Dina Merrill, who sat on the board for eighteen years and served on the compensation committee, which approved CEO Richard Fuld's $484 million in salary, stock, options, and bonuses from 2000 to 2007. Whatever their qualifications, the directors were well compensated, too. In 2007, each was paid between $325,038 and $397,538 for attending a total of eight full board meetings.

The average age of the Lehman board's risk committee was just under seventy. The committee was chaired by the eighty-one-year-old economist Henry Kaufman, who had last worked at a Wall Street investment bank some twenty years in the past and then started a consulting firm. He is exactly the type of director found on many boards—a person whose prestigious credentials are meant to reassure shareholders and regulators that the company is being well monitored and advised. Then they are ignored.

Kaufman had been on the Lehman board for thirteen years. Even in 2006 and 2007, as Lehman's borrowing skyrocketed and the firm was vastly increasing its holdings of very risky securities and commercial real estate, the risk committee met only twice each year. Kaufman was known as "Dr. Doom" back in the 1980s because of his consistently pessimistic forecasts as Salomon Brothers' chief economist, but he seems not to have been very persuasive with Lehman's executives in getting them to limit the massive borrowing and risks they were taking on as the mortgage bubble continued to over-inflate.

In an April 2008 interview, Kaufman offered an insight that might have been more timely and helpful a few years earlier in both the Lehman boardroom and Washington, D.C.: "If we don't improve the supervision and oversight over financial institutions, in another seven, eight, nine, or ten years, we may have a crisis that's bigger than the one we have today. . . . Usually what's happened is that financial markets move to the competitive edge of risk-taking unless there is some constraint." With little to no internal supervision, oversight, or constraint having been provided by its board, the bigger crisis for Lehman came sooner rather than later, and it collapsed just four and a half months later.

After Lehman's demise, Kaufman has continued to offer advice to others. Without a trace of irony or guilt, he said to another interviewer in July 2009, "If you want to take risks, you've got to have the capital to do it. But, you can't do it with other people's money where the other people are not well informed about the risk taking of that institution." In his recent book on financial system reform (which largely blames the Federal Reserve for the financial meltdown and has an entire section listing his own "prophetic" warnings about the economy), Kaufman neglects to mention either his role at Lehman or his missing the warning signs when he personally invested and lost millions in Bernie Madoff's Ponzi scheme. He does, however, note that "The shabby events of the recent past demonstrate that people in finance cannot and should not escape public scrutiny."

Dr. Doom did heed his own economic advice, while providing an instructive case of exquisite timing—as well as of having your cake, eating it too, and then patting yourself on the back for warning others of the caloric dangers of cake. Lehman securities filings show that about ten months before Lehman stock went to zero, Kaufman cashed in more than half of the remaining stock options that had been given to him for protecting shareholders' interests. He made nearly $2 million in profits.

"The Lehman board was a joke and a disgrace," said a former senior investment banker who now serves as a director for several S&P 500 companies. "Asleep at the switch doesn't begin to describe it." The autocratic Richard Fuld, whose nickname at the firm was "the Gorilla," had joined Lehman in 1969 when his air force career ended after he had a fistfight with a commanding officer. He served since 1994 as both CEO and chairman of the board, an inherent conflict in roles that still occurs at 61 percent of the largest U.S. companies.

A lawsuit filed in early 2009 by the New Jersey Department of Investment alleges that $118 million in losses to the state pension fund resulted from fraud and misrepresentation by Lehman's executives and the board. The role of the board is described in scathing terms:

The supine Board that defendant Fuld handpicked provided no backstop to Lehman's executives' zealous approach to the Company's risk profile, real estate portfolio, and their own compensation. The Director Defendants were considered inattentive, elderly, and woefully short on relevant structured finance background. The composition of the Board according to a recent filing in the Lehman bankruptcy allowed defendant "Fuld to marginalize the Directors, who tolerated an absence of checks and balances at Lehman." Due to his long tenure and ubiquity at Lehman, defendant Fuld has been able to consolidate his power to a remarkable degree. Defendant Fuld was both the Chairman of the Board and the CEO . . . The Director Defendants acted as a rubber stamp for the actions of Lehman's senior management. There was little turnover on the Board. By the date of Lehman's collapse, more than half of the Director Defendants had served for twelve or more years."

John Helyar is one of the authors of Barbarians at the Gate, which documents the fall of RJR Nabisco in the 1980s. He also cowrote a five-part series for Bloomberg.com on Lehman Brothers' collapse. Helyar was a keen observer of those companies' boards when they folded. "The few people on the Lehman board who actually had relevant experience were kind of like an all-star team from the 1980s back for an old-timers' game in which they weren't even up on the new rules and equipment," Helyar told us. "Fuld selected them because he didn't want to be challenged by anyone. Most of the top executives didn't understand the risks they were taking, so can you imagine a septuagenarian sitting in the boardroom getting a PowerPoint presentation on synthetic CDOs and credit default swaps?"

In a conference call announcing the firm's 2008 third-quarter loss of $3.9 billion, Fuld told analysts, "I must say the board's been wonderfully supportive." Four days later the 159-year-old company declared the largest bankruptcy in U.S. history. The Lehman shareholders, represented by the board, lost more than $45 billion.

THE DISASTERS at Merrill Lynch, GM, and Lehman were not isolated instances of hubris, incompetence, and negligence. Similar stories of boards and CEOs failing to do their jobs on behalf of the companies' owners can be told about Countrywide, Citigroup, AIG, Fannie Mae, Bank of America, Washington Mutual, Wachovia, Sovereign Bank, Bear Stearns, and most of the other companies directly involved in the recent financial meltdown, as well as many nonfinancial businesses whose governance-related troubles came to light in the resulting recession. In the short term, the result has been the loss of hundreds of billions of dollars for shareholders, and economic devastation for employees and others caught in the wake. In the long term, a growing crisis of confidence among investors could cripple our economy, as capital is diverted away from American corporate debt and equity markets and companies suffocate from lack of funding.

Investor mistrust takes hold fast and punishes instantly in the modern economy. Enron, once America's seventh-largest corporation, crashed in a mere three weeks once the scope of its failures and corruption was exposed and its investors and creditors began to withdraw their funds. Today's collapses can happen even faster. Because the companies are larger, their operations more interconnected, and their financing so complex and subject to hair-trigger reactions from institutional investors with enormous trading positions, the impacts are greatly magnified and reverberate globally. Bear Stearns went from its CEO claiming on CNBC that "our liquidity position has not changed at all" to being insolvent two days later.

Of the world's two hundred largest economies, more than half are corporations. They have more influence on our lives than any other institution—not just profound economic clout, but also enormous political, environmental, and civic power. As they have grown in influence, they have also become more concentrated: In 1950, the 100 largest industrial companies owned approximately 40 percent of total U.S. industrial assets; by the 1990s, they controlled 75 percent. Global corporations have assumed the authority and impact that formerly belonged to governments and churches. Boards of directors are supposed to be the most important element of corporate leadership—the ultimate power in this economic universe—and while some companies have made progress during the past decade in improving corporate governance, the recurring waves of scandals and the blatant victimization of shareholders that appear in the wake of economic crashes prove that our approach to leading corporations is badly in need of fundamental reform.

Ideally, a board of directors is informed, active, and advisory, and maintains an open but challenging relationship with the company's CEO. In reality, this rarely happens. In most cases, board members are beholden to CEOs for their very presence on the board, for their renominations, their compensation, their perquisites, their committee assignments, their agendas, and virtually all their information. Even well-intentioned directors find themselves hopelessly compromised, badly conflicted, and essentially powerless. Not that all blame can be put on bullying, manipulative CEOs; many boards simply fail to do their jobs. They allow themselves to be fooled by fraudulent accounting; they look away during the squandering of company resources; they miss obvious strategic shifts in the marketplace; they are blind to massive risks their firms assume; they approve excessive executive pay; they neglect to prepare for crises; they ignore blatant conflicts of interest; they condone a lax ethical tone. The head of one of the world's largest and most successful private equity firms told us that he considers the current model of corporate boards "fundamentally broken."

Continued in article

Hope this helps,
Bob Jensen

Question
Why do sales (cash) discounts have such high annual percentage rates?

Hi Pat and Tom,

In theory there may be justification for not treating the entire sales discount as interest revenue. When setting the amount of a sales discount, a vendor may be factoring in considerations other than time value of money.

There’s a concise illustration at http://snipurl.com/grossnet   

 

Note the last paragraph and the wording “about the same.”

There’s another consideration that I’ve not seen raised anywhere. If sales discounts are recorded net and the “Discount Not Taken” account is considered interest revenue, some discounts are so great that they might  be a violation of usury law in many states of the United States.

This begs the question of why sales discounts have such high APR amounts. The reason I think is that there are factors other than time value of money built into sales discounts. One such factor is that sales discounts may reduce the probabilities of bad debts. If a customer is on the edge and has to ration payoffs of accounts payable, the vendors with the highest sales discounts are likely to be paid off much faster than vendors with no sales discounts. It would be stupid for a customer to miss a sales discount and then ration payments of all accounts due at the end of the month.

Or put it in another way. Bad debt expense in reality is factored into the gross price of goods sold by vendors on account. Vendors that offer sales discounts are really rewarding customers who won’t become bad debts.

And there is another factor in setting a high APR for sales discounts. Vendors may be trying to buy customer loyalty and goodwill among their best customers who keep coming back in part because of the high sales discounts (without reasoning that the vendor might treat them even better with a lower gross price). This is what I would call a Dan Ariely argument ---
http://web.mit.edu/ariely/www/MIT/

Here’s the traditional basic accounting way “gross” sales discounts have been taught for maybe 100 years or more.

Video:  Sales Discounts --- http://www.youtube.com/watch?v=HV4ana221HU

It’s harder to find a video on the net method, possibly because basic accounting instructors often only teach the gross method so as not to complicate accounting instruction at the very earliest stages.

Bob Jensen

New Accounting Rule Lays Bare A Firm's Liability if Transaction Is Later Disallowed by the IRS

CPA auditors have always considered their primary role as attesting to full and fair corporate disclosures to investors and creditors under Generally Accepted Accounting Principles (GAAP). Now it turns out that this extends, perhaps unexpectedly, to the government as well.

"How Accounting Rule (FIN 48) Led to Probe Disclosure of Tax Savings Firms Regard as Vulnerable Leaves Senate Panel a Trail," by Jesse Drucker, The Wall Street Journal, September 11, 2007; Page A5 ---
http://online.wsj.com/article/SB118947026768923240.html?mod=todays_us_page_one

The probe, by the Senate's Permanent Subcommittee on Investigations, appears to have been sparked by an accounting rule known as FIN 48, which took effect in January. The rule for the first time requires companies to disclose how much they have set aside to pay tax authorities if certain tax-cutting transactions are successfully challenged by the government. The disclosures require companies to attach a dollar figure to tax-savings arrangements they think could be vulnerable.

Although intended to inform investors, the disclosures also serve as a kind of road map for government authorities, guiding them to companies that may have taken an aggressive stance on tax-related arrangements.

The probe, by the Senate's Permanent Subcommittee on Investigations, appears to have been sparked by an accounting rule known as FIN 48, which took effect in January. The rule for the first time requires companies to disclose how much they have set aside to pay tax authorities if certain tax-cutting transactions are successfully challenged by the government. The disclosures require companies to attach a dollar figure to tax-savings arrangements they think could be vulnerable.

Although intended to inform investors, the disclosures also serve as a kind of road map for government authorities, guiding them to companies that may have taken an aggressive stance on tax-related arrangements.

The FIN 48 disclosures generally reveal how much a company has set aside in an accounting reserve called "unrecognized tax benefits." The reserve represents the portion of the tax benefits realized on a company's tax return that also hasn't been recognized in its financial reporting.

In the letters, sent Aug. 23, Senate investigators seek to obtain more details about the underlying transactions in the FIN 48 disclosures. One letter viewed by The Wall Street Journal asks the companies to "describe any United States tax position or group of similar tax positions that represents five percent or more of your total [unrecognized tax benefit] for the period, including in the description of each whether the tax position involved foreign entities or jurisdictions."

The subcommittee, led by Sen. Carl Levin (D., Mich.), has held numerous hearings on tax shelters, tax avoidance, and the law firms and accounting firms that set up such structures.

The Senate's inquiry also includes questions about other tax-cutting arrangements. For tax-cutting transactions on which companies spent at least $1 million for legal fees or other costs, Senate investigators are asking companies to identify the amount of the tax benefit, as well as "the tax professional(s) who planned or designed the transaction or structure and the law firm(s) that authored the tax opinion or advice."

Continued in article

"Accounting for Uncertainty (FIN 48)," by Damon M. Fleming and Gerald E. Whittenburg, Journal of Accountancy, October 2007 --- --- http://www.aicpa.org/pubs/jofa/oct2007/uncertainty.htm

FASB Interpretation no. 48 (FIN 48), Accounting for Uncertainty in Income Taxes, sets the threshold for recognizing the benefits of tax return positions in financial statements as “more likely than not” (greater than 50%) to be sustained by a taxing authority. The effect is most pronounced where the uncertainty arises in the timing, amount or validity of a deduction.

Thresholds applicable to tax practitioners have been revised from a “realistic possibility” to “more likely than not” that a tax position will be sustained, as set forth in the U.S. Troop Readiness, Veterans’ Care, Katrina Recovery, and Iraq Accountability Appropriations Act of 2007 that was signed into law in May.

A third threshold, that a tax position possesses a “reasonable basis” in tax law, has been regarded as reflecting 25% certainty. In addition, taxpayers are subject to penalties if an understatement of liability is caused by a position that lacks “substantial authority,” a threshold for which no percentage of certainty has been established but has been regarded as between the reasonable-basis and more-likely-than-not standards.

Being familiar with the different thresholds for the reporting of uncertain tax positions can help CPAs effectively advocate for their clients’ tax positions and be impartial in financial reporting.

From The Wall Street Journal Accounting Weekly Review on June 1, 2007

FIN 48
October 21, 2009 message from Dennis Beresford [dberesfo@TERRY.UGA.EDU]

IRS Commissioner Doug Shulman spoke at a conference of the National Association of Corporate Directors that I attended earlier this week. He covered the income tax risk issues that directors should be concerned about. I thought this was a very good summary of both what auditors and tax accountants should be interested in and I refer interested parties to his posted remarks at:
http://media-newswire.com/release_1103133.html 

Denny Beresford

Bob Jensen's threads on FIN 48, 2009 ---
http://faculty.trinity.edu/rjensen/theory01.htm#FIN48

Bob Jensen's taxation helpers are at
http://faculty.trinity.edu/rjensen/BookBob1.htm#010304Taxation

Deferred Tax Asset Teaching Case

From The Wall Street Journal Accounting Weekly Review on May 27, 2011

Sony Expects Hefty Loss
by: Juro Osawa
May 24, 2011
Click here to view the full article on WSJ.com
 

TOPICS: Earning Announcements, Earnings Forecasts, Income Taxes, Supply Chains, Tax Deferrals

SUMMARY: "Sony Corp. warned it expects to post an annual loss of $3.2 billion, reversing a previous prediction of a return to profitability as the Japanese electronics giant struggles to recover from the March 11 earthquake and tsunami. Sony said it would take a $4.4 billion write-off on a certain portion of deferred tax assets in Japan, in what would be the company's third straight year of red ink....Sony said that under U.S. accounting standards, a third straight year of losses from the part of the company's operations based in Japan-due partly to the yen's strength-raised questions over the validity of its deferred tax assets in Japan."

CLASSROOM APPLICATION: The article is excellent for class use to cover deferred tax asset valuation allowances but it also touches on supply chain issues. The article is as well useful to discuss management forecasts (guidance), interim and annual reporting practices in Japan, foreign private issuers' filings on Form 20-F, and Sony's use of U.S. GAAP. One question also asks the students to consider whether the effects of the Great East Japan Earthquake and tsunami should be expected to be treated as extraordinary under U.S. GAAP. By the time students answer this last question, the company should have made its filing on Form 20-F which will allow for verification of the assessment.

QUESTIONS: 
1. (Introductory) Summarize your understanding of the announcement that Sony has made and that is reported in this article. For what time period is the company reporting? In your answer, comment on the usual fiscal year-end date for Japanese companies.

2. (Introductory) What is a deferred tax asset? What is a deferred tax asset valuation allowance?

3. (Introductory) For what reasons did Sony Corp. record deferred tax assets? Why must the company now write them down by establishing valuation allowances? In what reporting period will the company show the charge for this write down as a deduction in determining net income?

4. (Advanced) Why does this deferred tax asset write-down become an "admission that the March disaster has shattered its [Sony's] expectations for a robust current fiscal year"?

5. (Advanced) Access the Filing on Form 6-K which describes the investor briefing regarding the revision of management's forecast of consolidated results that is reported on in thie article. The filing is available at http://www.sec.gov/Archives/edgar/data/313838/000115752311003320/a6733820.htm Explain your understanding of the importance of the taxable income shown by "Sony Corporation as an unconsolidated unit and its consolidated tax filing group companies in Japan" to the loss that will be reported by Sony.

6. (Advanced) Why does Sony focus on the impact of the Japanese taxable income on accounting under U.S. GAAP? In your answer, comment on the financial reporting requirements for companies traded on U.S. stock exchanges.

7. (Introductory) What was the impact of the "Great East Japan Earthquake" on sales and operating profits in the last fiscal year? In the current year?

8. (Advanced) Do you think that the impact of the earthquake and tsunami described above will be give extraordinary item treatment under U.S. GAAP? Support your answer.
 

Reviewed By: Judy Beckman, University of Rhode Island

"Sony Expects Hefty Loss," by: Juro Osawa, The Wall Street Journal, May 24, 2011 ---
http://online.wsj.com/article/SB10001424052702304520804576340750302051690.html?mod=djem_jiewr_AC_domainid

Sony Corp. on Monday said it expects to post a $3.2 billion net loss for the just-ended fiscal year, blaming a $4.4 billion write-off on a certain portion of deferred tax assets in Japan, in what would be the company's third straight year of red ink.

The write-off is an admission from the entertainment and electronics conglomerate that the March 11 earthquake and tsunami has shattered its expectations for a robust current fiscal year. While the disaster's direct impact on the company's operating profit wasn't large, the post-quake outlook put Sony in a position where it had to set aside reserves of 360 billion yen on certain deferred tax assets in its fiscal fourth quarter.

Sony lowered its net outlook for the fiscal year that ended in March to a loss of 260 billion yen from the profit of 70 billion yen it forecast in February. In the previous fiscal year, the company racked up a loss of 40.8 billion yen.

The company, however, said it predicts a return to profitability for the current business year through March 2012.

Sony said that under U.S. accounting standards, a third straight year of losses from the part of the company's operations based in Japan—due partly to the yen's strength—raised questions over the validity of its deferred tax assets in Japan. But until March, Sony saw no need to write off the assets.

"Until the quake hit, we had been counting on a considerable recovery in earnings," in the current fiscal year, Sony Chief Financial Office Masaru Kato said at a news briefing.

But conditions have changed drastically since the earthquake and tsunami. In the wake of the disaster, Sony temporarily shut 10 plants in and around the quake-hit region. All but one of those plants have since resumed operations, at least partially.

Sony said the disaster siphoned off 22 billion yen from the company's sales and 17 billion yen from its operating profit in the just-ended business year.

The company left its forecast for operating profit unchanged at 200 billion yen, but lowered its revenue outlook to 7.18 trillion yen from 7.2 trillion yen.

Sony didn't disclose what it expects for the fiscal fourth quarter, but according to a Dow Jones Newswires calculation, it is estimated to have posted a net loss of 389.2 billion yen for the January-March quarter. That compares with a loss of 56.57 billion yen a year earlier.

Like other Japanese auto and electronics makers, Sony continues to face uncertainties because its recovery prospects are partially dependent on parts and materials suppliers, many of which have also been affected by the quake.

"The supply-chain situation should recover significantly in the second half of this fiscal year," Mr. Kato said.

In the current fiscal year, Sony estimates that the quake is likely to have a negative impact of about 440 billion yen on sales and 150 billion yen on operating profit, mainly through supply-chain disruptions.

Despite the quake's expected impact, Sony said it expects that its revenue will increase this fiscal year, and that its operating profit will be about the same as the previous fiscal year.

Continued in article

"CLEAN UP THE BALANCE SHEET: GET RID OF DEFERRED TAXES," by Anthony H. Catanach and J. Edward Ketz, Grumpy Old Accountants, August 13, 2012 ---
http://blogs.smeal.psu.edu/grumpyoldaccountants/archives/714

Jensen Comment
I don't always agree with the the Grumps, especially on lease accounting where they never really address really, really big issue of operating leases --- the issue of lease renewals. In the case of deferred taxes I'm inclined to agree but for a different reason. Deferred taxes constitute Reason 1,638,211 on how the accounting standard setters relegated the concept of earnings to a black hole in the universe.

Lifting the Veil on Tax Risk
by Jesse Drucker
The Wall Street Journal
May 25, 2007
Page: C1
Click here to view the full article on WSJ.com ---
http://online.wsj.com/article/SB118005869184314270.html?mod=djem_jiewr_ac
 

TOPICS: Accounting, Accounting Theory, Advanced Financial Accounting, Disclosure Requirements, Financial Accounting Standards Board, Financial Analysis, Financial Statement Analysis, Income Taxes

SUMMARY: FIN 48, entitled Accounting for Uncertainty in Income Taxes--An Interpretation of FASB Statement No. 109, was issued in June 2006 with an effective date of fiscal years beginning after December 15, 2006. As stated on the FASB's web site, "This Interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This Interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition." See the summary of this interpretation at http://www.fasb.org/st/summary/finsum48.shtml  As noted in this article, "in the past, companies had to reveal little information about transactions that could face some risk in an audit by the IRS or other government entities." Further, some concern about use of deferred tax liability accounts to create so-called "cookie jar reserves" useful in smoothing income contributed to development of this interpretation's recognition, timing and disclosure requirements. The article highlights an analysis of 361 companies by Credit Suisse Group to identify those with the largest recorded liabilities as an indicator of risk of future settlement with the IRS over disputed amounts. One example given in this article is Merck's $2.3 billion settlement with the IRS in February 2007 over a Bermuda tax shelter; another is the same company's current dispute with Canadian taxing authorities over transfer pricing. Financial statement analysis procedures to compare the size of the uncertain tax liability to other financial statement components and follow up discussions with the companies showing the highest uncertain tax positions also is described.

QUESTIONS: 
1.) Summarize the requirements of Financial Interpretation No. 48, Accounting for Uncertainty in Income Taxes--An Interpretation of FASB Statement No. 109 (FIN 48).

2.) In describing the FIN 48 requirements, the author of this article states that "until now, there was generally no way to know about" the accounting for reserves for uncertain tax positions. Why is that the case?

3.) Some firms may develop "FIN 48 opinions" every time a tax position is taken that could be questioned by the IRS or other tax governing authority. Why might companies naturally want to avoid having to document these positions very clearly in their own records?

4.) Credit Suisse analysts note that the new FIN 48 disclosures about unrecognized tax benefits provide investors with information about risks companies are undertaking. Explain how this information can be used for this purpose.

5.) How are the absolute amounts of unrecognized tax benefits compared to other financial statement categories to provide a better frame of reference for analysis? In your answer, propose a financial statement ratio you feel is useful in assessing the risk described in answer to question 4, and support your reasons for calculating this amount.

6.) The amount of reserves recorded by Merck for unrecognized tax benefits, tops the list from the analysis done by Credit Suisse and the one done by Professors Blouin, Gleason, Mills and Sikes. Based only on the descriptions given in the article, how did the two analyses differ in their measurements? What do you infer from the fact that Merck is at the top of both lists?

7.) Why are transfer prices among international operations likely to develop into uncertain tax positions?
 

Reviewed By: Judy Beckman, University of Rhode Island
 

From The Wall Street Journal Accounting Weekly Review on May 27, 2011

Sony Expects Hefty Loss
by: Juro Osawa
May 24, 2011
Click here to view the full article on WSJ.com
 

TOPICS: Earning Announcements, Earnings Forecasts, Income Taxes, Supply Chains, Tax Deferrals

SUMMARY: "Sony Corp. warned it expects to post an annual loss of $3.2 billion, reversing a previous prediction of a return to profitability as the Japanese electronics giant struggles to recover from the March 11 earthquake and tsunami. Sony said it would take a $4.4 billion write-off on a certain portion of deferred tax assets in Japan, in what would be the company's third straight year of red ink....Sony said that under U.S. accounting standards, a third straight year of losses from the part of the company's operations based in Japan-due partly to the yen's strength-raised questions over the validity of its deferred tax assets in Japan."

CLASSROOM APPLICATION: The article is excellent for class use to cover deferred tax asset valuation allowances but it also touches on supply chain issues. The article is as well useful to discuss management forecasts (guidance), interim and annual reporting practices in Japan, foreign private issuers' filings on Form 20-F, and Sony's use of U.S. GAAP. One question also asks the students to consider whether the effects of the Great East Japan Earthquake and tsunami should be expected to be treated as extraordinary under U.S. GAAP. By the time students answer this last question, the company should have made its filing on Form 20-F which will allow for verification of the assessment.

QUESTIONS: 
1. (Introductory) Summarize your understanding of the announcement that Sony has made and that is reported in this article. For what time period is the company reporting? In your answer, comment on the usual fiscal year-end date for Japanese companies.

2. (Introductory) What is a deferred tax asset? What is a deferred tax asset valuation allowance?

3. (Introductory) For what reasons did Sony Corp. record deferred tax assets? Why must the company now write them down by establishing valuation allowances? In what reporting period will the company show the charge for this write down as a deduction in determining net income?

4. (Advanced) Why does this deferred tax asset write-down become an "admission that the March disaster has shattered its [Sony's] expectations for a robust current fiscal year"?

5. (Advanced) Access the Filing on Form 6-K which describes the investor briefing regarding the revision of management's forecast of consolidated results that is reported on in thie article. The filing is available at http://www.sec.gov/Archives/edgar/data/313838/000115752311003320/a6733820.htm Explain your understanding of the importance of the taxable income shown by "Sony Corporation as an unconsolidated unit and its consolidated tax filing group companies in Japan" to the loss that will be reported by Sony.

6. (Advanced) Why does Sony focus on the impact of the Japanese taxable income on accounting under U.S. GAAP? In your answer, comment on the financial reporting requirements for companies traded on U.S. stock exchanges.

7. (Introductory) What was the impact of the "Great East Japan Earthquake" on sales and operating profits in the last fiscal year? In the current year?

8. (Advanced) Do you think that the impact of the earthquake and tsunami described above will be give extraordinary item treatment under U.S. GAAP? Support your answer.
 

Reviewed By: Judy Beckman, University of Rhode Island

"Sony Expects Hefty Loss," by: Juro Osawa, The Wall Street Journal, May 24, 2011 ---
http://online.wsj.com/article/SB10001424052702304520804576340750302051690.html?mod=djem_jiewr_AC_domainid

Sony Corp. on Monday said it expects to post a $3.2 billion net loss for the just-ended fiscal year, blaming a $4.4 billion write-off on a certain portion of deferred tax assets in Japan, in what would be the company's third straight year of red ink.

The write-off is an admission from the entertainment and electronics conglomerate that the March 11 earthquake and tsunami has shattered its expectations for a robust current fiscal year. While the disaster's direct impact on the company's operating profit wasn't large, the post-quake outlook put Sony in a position where it had to set aside reserves of 360 billion yen on certain deferred tax assets in its fiscal fourth quarter.

Sony lowered its net outlook for the fiscal year that ended in March to a loss of 260 billion yen from the profit of 70 billion yen it forecast in February. In the previous fiscal year, the company racked up a loss of 40.8 billion yen.

The company, however, said it predicts a return to profitability for the current business year through March 2012.

Sony said that under U.S. accounting standards, a third straight year of losses from the part of the company's operations based in Japan—due partly to the yen's strength—raised questions over the validity of its deferred tax assets in Japan. But until March, Sony saw no need to write off the assets.

"Until the quake hit, we had been counting on a considerable recovery in earnings," in the current fiscal year, Sony Chief Financial Office Masaru Kato said at a news briefing.

But conditions have changed drastically since the earthquake and tsunami. In the wake of the disaster, Sony temporarily shut 10 plants in and around the quake-hit region. All but one of those plants have since resumed operations, at least partially.

Sony said the disaster siphoned off 22 billion yen from the company's sales and 17 billion yen from its operating profit in the just-ended business year.

The company left its forecast for operating profit unchanged at 200 billion yen, but lowered its revenue outlook to 7.18 trillion yen from 7.2 trillion yen.

Sony didn't disclose what it expects for the fiscal fourth quarter, but according to a Dow Jones Newswires calculation, it is estimated to have posted a net loss of 389.2 billion yen for the January-March quarter. That compares with a loss of 56.57 billion yen a year earlier.

Like other Japanese auto and electronics makers, Sony continues to face uncertainties because its recovery prospects are partially dependent on parts and materials suppliers, many of which have also been affected by the quake.

"The supply-chain situation should recover significantly in the second half of this fiscal year," Mr. Kato said.

In the current fiscal year, Sony estimates that the quake is likely to have a negative impact of about 440 billion yen on sales and 150 billion yen on operating profit, mainly through supply-chain disruptions.

Despite the quake's expected impact, Sony said it expects that its revenue will increase this fiscal year, and that its operating profit will be about the same as the previous fiscal year.

Continued in article

Bob Jensen's threads on FIN 48 are at
http://faculty.trinity.edu/rjensen/Theory02.htm#FIN48

Teaching Case
When Rosie Scenario waved goodbye "Adjusted Consolidated Segment Operating Income"

From The Wall Street Journal Weekly Accounting Review on August 19, 2011

Groupon Bows to Pressure
by: Shayndi Raice and Lynn Cowan
Aug 11, 2011
Click here to view the full article on WSJ.com
 

TOPICS: Advanced Financial Accounting, SEC, Securities and Exchange Commission, Segment Analysis

SUMMARY: In filing its prospectus for its initial public offering (IPO), Groupon has removed from its documents "...an unconventional accounting measurement that had attracted scrutiny from securities regulators [adjusted consolidated segment operating income]. The unusual measure, which the e-commerce had invented, paints a more robust picture of its performance. Removal of the measure was in response to pressure from the Securities and Exchange Commission...."

CLASSROOM APPLICATION: The article is useful to introduce segment reporting and the weaknesses of the required management reporting approach.

QUESTIONS: 
1. (Introductory) What is Groupon's business model? How does it generate revenues? What are its costs? Hint, to answer this question you may access the Groupon, Inc. Form S-1 Registration Statement filed on June 2, 011 available on the SEC web site at http://www.sec.gov/Archives/edgar/data/1490281/000104746911005613/a2203913zs-1.htm

2. (Advanced) Summarize the reporting that must be provided for any business's operating segments. In your answer, provide a reference to authoritative accounting literature.

3. (Advanced) Why must the amounts disclosed by operating segments be reconciled to consolidated totals shown on the primary financial statements for an entire company?

4. (Advanced) Access the Groupon, Inc. Form S-1 Registration Statement filed on June 2, 011 and proceed to the company's financial statements, available on the SEC web site at http://www.sec.gov/Archives/edgar/data/1490281/000104746911005613/a2203913zs-1.htm#dm79801_selected_consolidated_financial_and_other_data Alternatively, proceed from the registration statement, then click on Table of Contents, then Selected Consolidated Financial and Other Data. Explain what Groupon calls "adjusted consolidated segment operating income" (ACSOI). What operating segments does Groupon, Inc., show?

5. (Introductory) Why is Groupon's "ACSOI" considered to be a "non-GAAP financial measure"?

6. (Advanced) How is it possible that this measure of operating performance could be considered to comply with U.S. GAAP requirements? Base your answer on your understanding of the need to reconcile amounts disclosed by operating segments to the company's consolidated totals. If it is accessible to you, the second related article in CFO Journal may help answer this question.
 

Reviewed By: Judy Beckman, University of Rhode Island
 

RELATED ARTICLES: 
Groupon's Accounting Lingo Gets Scrutiny
by Shayndi Raice and Nick Wingfield
Jul 28, 2011
Page: A1

CFO Report: Operating Segments Remain Accounting Gray Area
by Emily Chasan
Aug 15, 2011
Page: CFO

 

"Groupon Bows to Pressure," by: Shayndi Raice and Lynn Cowan, The Wall Street Journal, August 11, 2011 ---
https://mail.google.com/mail/?shva=1#inbox/131e06c48071898b

Groupon Inc. removed from its initial public offering documents an unconventional accounting measurement that had attracted scrutiny from securities regulators.

The unusual measure, which the e-commerce had invented, paints a more robust picture of its performance. Removal of the measure was in response to pressure from the Securities and Exchange Commission, a person familiar with the matter said.

In revised documents filed Wednesday with the SEC, the company removed the controversial measure, which had been highlighted in the first three pages of its previous filing. But Groupon's chief executive defended the term Wednesday. [GROUPON] Getty Images

Groupon, headquarters above, expects to raise about $750 million.

Groupon had highlighted something it called "adjusted consolidated segment operating income", or ACSOI. The measurement, which doesn't include subscriber-acquisitions expenses such as marketing costs, doesn't conform to generally accepted accounting principles.

Investors and analysts have said ACSOI draws attention away from Groupon's marketing spending, which is causing big net losses.

The company also disclosed Wednesday that its loss more than doubled in the second quarter from a year ago, even as revenue increased more than ten times.

By leaving ACSOI out of its income statements, the company hopes to avoid further scrutiny from the SEC, the person familiar with the matter said. The commission declined comment.

Groupon in June reported ACSOI of $60.6 million for last year and $81.6 million for the first quarter of 2011. Under generally accepted accounting principles, the company generated operating losses of $420.3 million and $117.1 million during those periods.

Wednesday's filing included a letter from Groupon Chief Executive Andrew Mason defending ACSOI. The company excludes marketing expenses related to subscriber acquisition because "they are an up-front investment to acquire new subscribers that we expect to end when this period of rapid expansion in our subscriber base concludes and we determine that the returns on such investment are no longer attractive," the letter said.

There was no mention of when that expansion will end, but the person familiar with the matter said the company reevaluates the figures weekly.

Groupon said it spent $345.1 million on online marketing initiatives to acquire subscribers in the first half and that it expects "to continue to expend significant amounts to acquire additional subscribers."

The latest SEC filing also contains new financial data. Groupon on Wednesday reported second-quarter revenue of $878 million, up 36% from the first quarter. While the company's growth is still rapid, the pace has slowed. Groupon's revenue jumped 63% in the first quarter from the fourth.

The company's second-quarter loss was $102.7 million, flat sequentially and wider than the year-earlier loss of $35.9 million.

Groupon expects to raise about $750 million in a mid-September IPO that could value the company at $20 billion.

The path to going public hasn't been easy. The company had to file an amendment to its original SEC filing after a Groupon executive told Bloomberg News the company would be "wildly profitable" just three days after its IPO filing. Speaking publicly about the financial projections of a company that has filed to go public is barred by SEC regulations. Groupon said the comments weren't intended for publication.

Continued in article

From The Wall Street Journal Weekly Accounting Review on September 30, 2011

Groupon Unsure on IPO Time
by: Shayndi Raice and Randall Smith
Sep 26, 2011
Click here to view the full article on WSJ.com
Click here to view the video on WSJ.com 
 

TOPICS: Accounting Changes and Error Corrections, Audit Report, Auditing, Disclosure, Disclosure Requirements, Financial Accounting, Financial Reporting, SEC, Securities and Exchange Commission

SUMMARY: This article presents financial reporting and auditing issues stemming from the Groupon planned IPO. Groupon originally filed for an initial public offering in June 2011. At the time, the filing contained a measure Adjusted Consolidated Segment Operating Income that is a non-GAAP measure of performance. The SEC at the time required the company to change its filing to use GAAP-based measures of performance. The SEC has continued to scrutinize the Groupon financial statements and has required the company to report revenue based only on the net receipts to the company from sales of its coupons after sharing proceeds with the businesses for which it makes the coupon offers.

CLASSROOM APPLICATION: The article is useful in financial accounting and auditing classes. Instructors of financial accounting classes may use the article to discuss reporting of the change in measuring revenues and related costs. Instructors of auditing classes may use the article to discuss non-standard audit reports. Links to SEC filings are included in the questions. The video is long; discussion of Groupon's issues stops at 5:30.

QUESTIONS: 
1. (Introductory) According to the article, what accounting and disclosure issues have delayed the initial public offering of shares of Groupon, Inc.? What overall economic and financial factors are also affecting this timing?

2. (Introductory) What was the problem with Groupon CEO Andrew Mason's letter to Groupon employees? Do you think Mr. Mason intended for this letter to be made public outside of Groupon? Should he have reasonably expected that to happen?

3. (Advanced) What accounting change forced restatement of the financial statements included in the Groupon IPO filing documents? You may access information about this restatement directly at the live link included in the online version of the article. http://online.wsj.com/public/resources/documents/grouponrestatement20110923.pdf

4. (Introductory) According to the article, by how much was revenue reduced due to this accounting change?

5. (Introductory) Access the full filing of the IPO documents on the SEC's web site at http://sec.gov/Archives/edgar/data/1490281/000104746911008207/a2205238zs-1a.htm Proceed to the Consolidated Statements of Operations on page F-5. How are these comparative statements presented to alert readers about the revenue measurement issue?

6. (Advanced) Move back to examine the consolidated balance sheets on page F-4. Do you think this accounting change for revenue measurement affected net income as previously reported? Support your answer.

7. (Advanced) Proceed to footnote 2 on p. F-8. Does the disclosure confirm your answer? Summarize the overall impact of these accounting changes as described in this footnote.

8. (Advanced) What type of audit report has been issued on the Groupon financial statements in this IPO filing? Explain the wording and dating of the report that is required to fulfill requirements resulting from the circumstances of these financial statements.
 

Reviewed By: Judy Beckman, University of Rhode Island
 

---

 

Groupon's Fast-growing Business Faces a Churning Point
by: Rolfe Winkler
Sep 26, 2011
Click here to view the full article on WSJ.com
Click here to view the video on WSJ.com 
 

TOPICS: Cost Accounting, Cost Management, Disclosure, Financial Statement Analysis, Managerial Accounting

SUMMARY: This article focuses on financial statement analysis of the Groupon IPO filing documents including some references to cost measures. "Forget the snappy 'adjusted consolidated segment operating income.' That profit measure...was rightly rejected by regulators. It is the complete absence of details on subscriber churn that is more problematic. How often are folks unsubscribing from Groupon's daily emails?...The issue is important since...the cost of adding new subscribers has increased quickly."

CLASSROOM APPLICATION: The article may be used in a financial statement analysis or managerial accounting class.

QUESTIONS: 
1. (Introductory) What is the overall concern about Groupon's business condition that is expressed in this article?

2. (Advanced) The author states that the cost of adding new subscribers has increased. How was this cost determined? How does this calculation make the cost assessment comparable from one period to the next?

3. (Advanced) What does Groupon CEO Andrew Mason say about the company's cost of acquiring customers? What income statement expense item shows this cost? How does the increasing unit cost discussed in answer to question 2 above bring the CEO's assertion into question?

4. (Advanced) In general, how does the author of this assess the quality of the filing by Groupon for its initial public offering? Why should that assessment impact the thoughts of an investor considering buying the Groupon stock when it is offered?
 

Reviewed By: Judy Beckman, University of Rhode Island

Jensen Comment
In the 1990s, high tech companies resorted to various accounting gimmicks to increase the price and demand for their equity shares ---
http://faculty.trinity.edu/rjensen/ecommerce/eitf01.htm

"The trouble with tax tricks:  Companies' tax avoidance schemes inflate profits and distort the market – those responsible must be made to come clean," by Prem Sikka, The Guardian, April 4, 2009 --- http://www.guardian.co.uk/commentisfree/2009/apr/03/tax-avoidance-economics

Any action from G20 leaders who have focused on tax havens and are promising reforms would be welcomed, as many countries are losing tax revenues that could be used to improve social infrastructure. However, none have made any commitment to force companies to explain how their profits are inflated by tax avoidance schemes. This has serious consequences for managing the domestic economy and equity between corporate stakeholders.

Tax avoidance has created a mirage of large corporate profits, which has turned many a CEO into a media star and even secured knighthoods and peerages for some. Yet the profits have been manufactured by a sleight of hand. Let us get back to the basics. To generate wealth, at the very least, three kinds of capital need to be invested. Shareholders invest finance capital and expect to receive a return. Markets exert pressure for this to be maximised. Employees invest human capital and expect to receive a return in the shape of wages and salaries. Society invests social capital (health, education, family, security, legal system) and expects a return in the shape of taxes. Over the years, corporate tax rates have been reduced, but the return on social capital is under constant attack by tax avoidance schemes. The aim is to transfer the return accruing to society to shareholders. Companies have reported higher profits, not because they undertook higher economic activity or produced more desirable goods and services, but simply by expropriating the returns due to society. This can only be maintained as long as governments and civil society remain docile.

Companies engaging in tax avoidance schemes publish higher profits but do not explain the impact of tax avoidance schemes on these profits. Consequently, markets cannot make assessment of the quality of their earnings, ie how much of the profit is due to production of goods and services and thus sustainable, and how much is due to expropriation of wealth from society. In the absence of such information, markets cannot make a rational assessment of future cashflows accruing to shareholders. Inevitably, market assessment of risk is mispriced and resources are misallocated. By concealing tax avoidance schemes, companies have deliberately provided misleading information to markets. The subsequent imposition of penalties for tax avoidance, if any, will reduce future company profits. But the cost will be borne by the then shareholders rather than by the earlier shareholders who benefited from the tax scams. Thus the secrecy surrounding tax avoidance schemes causes involuntary wealth transfers and must also undermine confidence in corporations because they are not willing to come clean.

Governments collect data on corporate profits to gauge the health of the economy and develop economic policies. However, this barometer is misleading too because it does not distinguish between normal commercial sustainable profits and profits inflated by tax avoidance.

Company executives are major beneficiaries of tax avoidance because their remuneration is frequently linked to reported profits. They can increase these through production of goods and services, but many have deliberately chosen to raid the taxes accruing to society. Company executives could provide honest information and explain how much of their remuneration is derived from the use of tax avoidance schemes, but none have done so. As a result, no shareholder or regulator can make an objective assessment of company performance, executive performance or remuneration. By the time the taxman catches up with the company and imposes fines and penalties, many an executive has moved on to newer pastures and is not required to return remuneration to meet any portion of those penalties. Seemingly, there are no penalties for artificially inflating executive remuneration.

Under the UK Companies Act 2006, company directors have a duty to avoid conflicts of interests. They are required to promote the success of the company for the benefit of its members, which is taken to mean "long-term increase in value" and must also publish "true and fair" accounts. It is difficult to see how such obligations can be discharged by systematic misleading of markets, shareholders, governments and taxpayers. Hopefully, stakeholders will bring test cases.

From The Wall Street Journal Accounting Weekly Review on March 23, 2012

Disney's $200 Million Charge
by: Erica Orden
Mar 20, 2012
Click here to view the full article on WSJ.com
 

TOPICS: Earnings Forecasts, Financial Accounting, Financial Statements, Fiscal Year, Segment Analysis, Segment Margins

SUMMARY: The article describes a significant loss in one segment of Walt Disney Co.'s operations, Studio Entertainment, based on poor box office results for the first 10 days of the movie's release. The earnings guidance being offered by management in advance of fiscal third quarter earnings, the quarter will end at approximately March 31, 2012 based on a 52-week fiscal year ending around September 30. Questions ask students to access financial statement filings on Form 10-K and 10-Q to confirm information in the article.

CLASSROOM APPLICATION: NOTE: Instructors will want to delete the following information: the answer to question 5 can be found in the 10-Q filing for the quarter ended April 2, 2011 and filed on May 5, 2011, and available at http://www.sec.gov/cgi-bin/viewer?action=view&cik=1001039&accession_number=0001193125-11-134405&xbrl_type=v. Click on notes to financial statements, Segment Information, and see the $77 million segment operating income for the Studio Entertainment segment in the second panel.

QUESTIONS: 
1. (Introductory) What is the impact of one movie, "John Carter," on the operations of Walt Disney Co.?

2. (Introductory) Is this impact on Disney's total operations or something else? Explain.

3. (Advanced) Based on information given in the article, determine Walt Disney Co.'s fiscal year end date. Why do you think this company has such a year end date?

4. (Advanced) Access the most recent filing of Walt Disney Company's annual financial statements by clicking on the live link to Walt Disney Co. in the article, scrolling down the page, and clicking on SEC Filings in the lower right hand corner. Search for filings on Form 10-K. Find information on Disney's operating segments and confirm your answers to questions 2 and 3, explaining how you do so.

5. (Advanced) Disney "rarely offers such advance financial guidance" as it is giving in the information on which this article reports. Why do you think the company is doing so now?

6. (Advanced) According to the article, the expected loss of between $80 million and $120 million Disney has announced compares to "an operating profit of $77 million during the same quarter last year." In what financial statement filing can you find that information?
 

Reviewed By: Judy Beckman, University of Rhode Island

 

"Disney's $200 Million Charge," by Erica Orden, The Wall Street Journal, March 23, 2012 ---
http://online.wsj.com/article/SB10001424052702304724404577291972883469132.html?mod=djem_jiewr_AC_domainid

Walt Disney Co. DIS +0.05% expects to lose $200 million on its science-fiction epic "John Carter," the company said on Monday, citing the costly movie's weak box-office performance.

As a result, Disney added, its movie studio is expected to report an operating loss of between $80 million and $120 million for its fiscal second quarter, ending March 31. Disney won't report its earnings for the quarter until May, and rarely offers such advance financial guidance.

Walt Disney Co. DIS +0.05% expects to lose $200 million on its science-fiction epic "John Carter," the company said on Monday, citing the costly movie's weak box-office performance.

As a result, Disney added, its movie studio is expected to report an operating loss of between $80 million and $120 million for its fiscal second quarter, ending March 31. Disney won't report its earnings for the quarter until May, and rarely offers such advance financial guidance.

Continued in article

Tutorial:  FIN 48 from different perspectives
Financial Accounting Standards Board Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes, is intended to substantially reduce uncertainty in accounting for income taxes. Its implementation and infrastructure requirements, however, generate a great deal of uncertainty. This feature provides an overview of FIN 48, addresses some of its federal and international tax issues, as well as issues arising at the state and local level.
AccountingWeb, June 2007 --- http://www.accountingweb.com/cgi-bin/item.cgi?id=103625

"GM Will Book $39 Billion Charge Write-Down of Tax Credits Indicates That Profits Won't Come in Near Term," by John D. Stoll, The Wall Street Journal, November 7, 2007; Page A3 --- http://online.wsj.com/article/SB119438884709884385.html?mod=todays_us_page_one

General Motors Corp. will take a $39 billion, noncash charge to write down deferred-tax credits, a signal that it expects to continue to struggle financially despite significant restructuring and cost cutting in the past two years.

The deferred-tax assets stem from losses and could be used to offset taxes on current or future profits for a certain number of years.

In after-hours trading, GM fell 2.9% to $35.14. Before the disclosure, its shares finished at $36.16, up 16 cents, or less than 1%, in New York Stock Exchange composite trading.

GM, the world's largest auto maker in vehicle sales, was to report third-quarter financial results today. The company, which was stung by big losses in 2005 and 2006, said the write-down was triggered by three main issues: a string of adjusted losses in core North American operations and Germany over the past three years, weakness at its GMAC Financial Services unit, and the long duration of tax-deferred assets.

GM had appeared to be making progress in stemming its losses. Its global automotive operations were profitable in the first half of the year. It recently signed a labor deal with the United Auto Workers that allows it to establish an independent trust to absorb its approximately $50 billion in hourly retiree health-care liabilities. The move promises to significantly reduce GM's cash health-care expenses and combine with other labor-cost cuts in creating a more profitable North American arm.

If it returns to steady profits, GM could remove the valuation allowance and reclaim some or all of the $39 billion in deferred credits.

For now, the massive charge promises to devastate GM's headline financial results for the third quarter, and for the year, likely leading to the worst annual loss in its 99-year history. Although the charge is an accounting loss that doesn't involve cash, it is still a staggering sum. By comparison, the company reported a total of $34 billion in net income from 1996 to 2004.

GM will partially offset the charge with a gain of more than $5 billion related to the sale of its Allison Transmission unit.

The charge follows more than $12 billion in losses since the beginning of 2005. GM has been scrambling to cut the size of its U.S. operation amid shrinking market share, rising costs and a rapidly globalizing auto industry. Its restructuring has been complicated by a slowdown in U.S. demand for automobiles and losses at GMAC.

The lending giant lost $1.6 billion in the third quarter, the biggest quarterly setback since at least the 1960s. It made money on auto lending and insurance but was dragged down by a $1.8 billion setback at ResCap, its residential-mortgage business and a big player in subprime loans. GM's exposure is limited because it sold 51% of GMAC to Cerberus Capital Management LP last year. In the past, GMAC delivered dividends to GM, including more than $9 billion in the decade before the GMAC sale.

The write-down isn't expected to affect GM's liquidity position, which stood at $27.2 billion as of June 30. GM has been selling noncore assets in recent years to pad its bank account. In addition, GM Chief Financial Officer Frederick "Fritz" Henderson said the write-down won't preclude it from using loss carry-forwards or other deferred-tax assets in the future. It is unclear whether GM's plunge deeper into negative shareholder-equity status will affect it's borrowing capabilities or credit rating.

The latest disclosure underscores the challenge Chief Executive Officer Richard Wagoner faces in seeking a full-scale turnaround as GM hangs on to its No. 1 global-sales ranking over Toyota Motor Corp. by a thread. Delphi Corp., GM's top supplier, has failed in attempts to emerge from bankruptcy protection, so GM must wait indefinitely on cost savings it hopes to gain from a reorganized Delphi. Also, U.S. automobile demand has withered to the lowest point in a decade, and, as oil futures continue to escalate, pressure on high-profit trucks and SUVs remains firm.

Denny Beresford provided a link to another reference --- Click Here

November 7, 2008 reply from Amy Dunbar [Amy.Dunbar@BUSINESS.UCONN.EDU]

>So they think it is more likely than not that they will receive zero tax benefit from their tax loss carryforwards! 

Hmmmmm, I doubt that is what GM thinks. As the news release stated, "In making such judgments, significant weight is given to evidence that can be objectively verified. A company's current or previous losses are given more weight than its future outlook, and a recent three-year historical cumulative loss is considered a significant factor that is difficult to overcome." FAS 109, P 23 states, "Forming a conclusion that a valuation allowance is not needed is difficult when there is negative evidence such as cumulative losses in recent years."

As an aside, the more-likely-than-not standard in FAS 109 existed before FIN 48 adopted the standard. FIN 48 doesn't talk about objective evidence wrt the MLTN standard.

FIN 48, 6, states, "An enterprise shall initially recognize the financial statement effects of a tax position when it is more likely than not, based on the technical merits, that the position will be sustained upon examination. As used in this Interpretation, the term more likely than not means a likelihood of more than 50 percent; the terms examined and upon examination also include resolution of the related appeals or litigation processes, if any. The more-likely than- not recognition threshold is a positive assertion that an enterprise believes it is entitled to the economic benefits associated with a tax position. The determination of whether or not a tax position has met the more-likely-than-not recognition threshold shall consider the facts, circumstances, and information available at the reporting date.

FIN 48, 7, states, "In assessing the more-likely-than-not criterion as required by paragraph 6 of this Interpretation: a. It shall be presumed that the tax position will be examined by the relevant taxing authority that has full knowledge of all relevant information. b. Technical merits of a tax position derive from sources of authorities in the tax law (legislation and statutes, legislative intent, regulations, rulings, and case law) and their applicability to the facts and circumstances of the tax position. When the past administrative practices and precedents of the taxing authority in its dealings with the enterprise or similar enterprises are widely understood, those practices and precedents shall be taken into account. c. Each tax position must be evaluated without consideration of the possibility of offset or aggregation with other positions."

In an appendix, FIN 48, B46, states, "In considering the subsequent recognition of tax positions that do not initially meet the more-likely-than-not recognition threshold and the subsequent measurement of tax positions, the Board initially considered whether specific external events should be required to effect a change in judgment about the recognition of a tax position or the measurement of a recognized tax position. The Board concluded in the Exposure Draft that a change in estimate is a judgment that requires evaluation of all available facts and circumstances, not a specific triggering event. Some respondents to the Exposure Draft stated that the evidence supporting a change in judgment should be objectively verifiable and that a triggering event is normally required to subsequently recognize a tax benefit."

Since this language wasn't put in the standard, I wonder if one could argue that the two MLTN standards are different. It would be interesting to be a fly on the wall as some of the debate goes on about uncertain tax positions.

Amy Dunbar

From The Wall Street Journal Accounting Weekly Review on November 9, 2007

GM Will Book $39 Billion Charge by John D. Stoll Nov 07, 2007 Page: A3 Click here to view the full article on WSJ.com --- http://online.wsj.com/article/SB119438884709884385.html?mod=djem_jiewr_ac   TOPICS: Advanced Financial Accounting, Income Taxes SUMMARY: "General Motors Corp. will take a $39 billion, noncash charge to write down deferred tax assets, "...a signal that it expects to continue to struggle financially despite significant restructuring and cost cutting in the past two years." CLASSROOM APPLICATION: Use to cover accounting for deferred tax assets and a related valuation account. QUESTIONS:  1.) Define the terms deferred tax assets, deferred tax liabilities, net operating loss carryforwards, and deferred tax credits. 2.) Which of the above three items has General Motors recorded for a total of $39 billion? In your answer, comment on the opening statement in the article that GM will write-down its "deferred tax credits." 3.) What is a valuation allowance against deferred tax assets? When must such an allowance be recorded under generally accepted accounting standards? Use GM's situation as an example in your answer. 4.) GM states that its $39 billion write down was impacted by three factors. Explain how each of these factors bears on the determination of a valuation allowance against deferred tax assets. Be specific. 5.) The author writes, "If it returns to steady profits, GM could remove the valuation allowance and reclaim some or all of the $39 billion in deferred credits," and that the write-down does not preclude GM from future use of its net operating loss carryforwards and deferred tax assets. Explain these statements, including the entries that will be recorded if the deferred tax assets are used in the future.   Reviewed By: Judy Beckman, University of Rhode Island   RELATED ARTICLES:  GM Statement on Noncash Charge by General Motors, via PRNewswire Nov 06, 2007 Online Exclusive

Controversy Over FAS 2 versus IAS 38 on Research and Development (R&D)

"Failed Convergence of R&D Accounting::  Only Politicians and Opportunists Would Have Downplayed the Implications," by Tom Selling, The Accounting Onion, June 5, 2010 --- Click Here
http://accountingonion.typepad.com/theaccountingonion/2010/06/failed-convergence-of-rd-accounting-only-politicians-and-opportunists-would-have-downplayed-the-implications.html?utm_source=feedburner&utm_medium=email&utm_campaign=Feed%3A+typepad%2Ftheaccountingonion+%28The+Accounting+Onion%29

Bob Jensen's threads on IASB-FASB standards convergence ---
http://faculty.trinity.edu/rjensen/Theory01.htm#MethodsForSetting

"Is Accounting Blocking R&D Investments?  Companies should resist the urge to cut research expenses to meet an earnings per share target," John R. Cryan, Joseph Theriault,  CFO.com, December 5, 2012 ---
http://www3.cfo.com/article/2012/12/cash-flow_rd-eps-ebitda-accounting-treatment-of-rd

Jensen Comment
The "principles-based" IFRS allows for more subjectivity in capitalizing versus expensing R&D relative to US GAAP having more bright lines

From The Wall Street Journal Accounting Weekly Review on November 12, 2009

3. (Advanced) Focusing on accounting issues, state why cutting R&D operations quickly impact any company's financial performance in a current accounting period. In you answer, first address the question considering U.S. accounting standards.

4. (Advanced) Does your answer to the question above change when considering reporting practices under IFRS?

Pfizer Shuts Six R&D Sites After Takeover
by Jonathan D. Rockoff
Nov 10, 2009
Click here to view the full article on WSJ.com

TOPICS: Consolidation, GAAP, International Accounting, Mergers and Acquisitions, Research & Development

SUMMARY: "Pfizer Inc., digesting its $68 billion takeover of rival Wyeth last month, said Monday it will close six of its 20 research sites, in the latest round of cost cutting by retrenching drug makers....Pfizer executives wanted to cut costs quickly so the integration didn't stall research....'When we acquired Warner-Lambert, it took us almost two years to get into the position we will be in 30 to 60 days' after closing the Wyeth deal, Martin Mackay, one of Pfizer's two R&D chiefs, said in an interview."

CLASSROOM APPLICATION: Questions relate to understanding the immediate implications of reducing R&D expenditures for current period profit under both U.S. GAAP and IFRS as well as to understanding pharmaceutical industry consolidation and restructuring.

QUESTIONS: 
1. (Introductory) What are the business issues within the pharmaceuticals industry in particular that are driving the need to reduce costs rapidly? In your answer, comment on industry consolidations and restructuring, including definitions of each of these terms.

2. (Introductory) What business reasons specific to Pfizer did their executives offer as reasons to cut R&D costs quickly?

3. (Advanced) Focusing on accounting issues, state why cutting R&D operations quickly impact any company's financial performance in a current accounting period. In you answer, first address the question considering U.S. accounting standards.

4. (Advanced) Does your answer to the question above change when considering reporting practices under IFRS?

Reviewed By: Judy Beckman, University of Rhode Island

RELATED ARTICLES: 
Pfizer to Pay $68 Billion for Wyeth
by Matthew Karnitschnig
Jan 26, 2009
Page: A1

The Wall Street Journal, November 10, 2009 ---
http://online.wsj.com/article/SB10001424052748703808904574525644154101608.html?mod=djem_jiewr_AC

Pfizer Inc., digesting its $68 billion takeover of rival Wyeth last month, said Monday it will close six of its 20 research sites, in the latest round of cost cutting by retrenching drug makers.

Pfizer was expected to cut costs as part of its consolidation with Wyeth, and research and development was considered a prime target because the two companies' combined R&D budgets totaled $11 billion. In announcing the laboratory shutdowns Monday, Pfizer didn't say how many R&D jobs it would cut or how much it hoped to save from the shutdowns.

For much of this decade, pharmaceutical companies have been closing labs, laying off researchers and outsourcing more work from their once-sacrosanct R&D units. Pfizer previously closed several labs, including the Ann Arbor, Mich., facility where its blockbuster cholesterol fighter Lipitor was developed. In January, before the Wyeth deal was announced, Pfizer said it would lay off as many as 800 researchers.

But analysts say Pfizer Chief Executive Jeffrey Kindler and other industry leaders haven't done enough. A major reason for the industry consolidation this year is the opportunity to slash spending further.

Pfizer previously said it expects $4 billion in savings from its combination with Wyeth. It plans to eliminate about 19,500 jobs, or 15% of the combined company's total.

Merck & Co., which completed its $41.1 billion acquisition of Schering-Plough last week, is expected to cut 15,930 jobs, or about 15% of its work force. In September, Eli Lilly & Co. said it will eliminate 5,500 jobs, or nearly 14% of its total. Johnson & Johnson said last week that it will pare as many as 8,200 jobs, or 7%.

Drug makers are restructuring in anticipation of losing tens of billions of dollars in revenues as blockbuster products, such as Lipitor, start facing competition from generic versions. Setbacks developing new treatments have made the need to reduce spending all the more urgent, analysts say, and have reduced resistance to closing labs. The economic slump has only worsened the pharmaceutical industry's plight, pressuring sales.

The sites Pfizer is set to close include Wyeth's facility in Princeton, N.J., which has been working on promising therapies for Alzheimer's disease, including one called bapineuzumab under development by several companies. The Alzheimer's work will move to Pfizer's lab in Groton, Conn., which will be the combined company's largest site. The consolidation of Alzheimer's work "allows us to fully focus on that, rather than have to coordinate activities," said Mikael Dolsten, a former Wyeth official and one of two R&D chiefs at the combined company.

Besides Princeton, Pfizer said research also is scheduled to end at R&D sites in Chazy, Rouses Point and Plattsburgh, N.Y.; Gosport, Slough and Taplow in the U.K.; and Sanford and Research Triangle Park, N.C. Pfizer is counting as a single site labs close to each other, such as the facilities in Rouses Point and Plattsburgh, Slough and Taplow, and Sanford and Research Triangle Park. Along with the Princeton facility, those in Chazy, Rouses Point and Sanford had belonged to Wyeth.

The company is also planning to move work from its Collegeville, Pa.; Pearl River, N.Y., and St. Louis sites to other locations.

Pfizer executives wanted to cut costs quickly after the Wyeth deal's completion so the integration doesn't stall research. That was a problem with Pfizer's acquisition of Warner-Lambert in 2000 and its merger with Pharmacia in 2003. As a result, critics say the deals destroyed billions of dollars in shareholder value. Pfizer says it has learned from its past acquisitions.

"When we acquired Warner-Lambert, it took us almost two years to get into the position we will be in 30 to 60 days" after closing the Wyeth deal, Martin Mackay, one of Pfizer's two R&D chiefs, said in an interview. Up next, he said, the newly combined company will prioritize its R&D work and decide which potential therapies to abandon.

Comparisons of IFRS with Domestic Standards of Many Nations
http://www.iasplus.com/country/compare.htm

More Detailed Differences (Comparisons) between FASB and IASB Accounting Standards

2011 Update

"IFRS and US GAAP: Similarities and Differences" according to PwC (2011 Edition)
http://www.pwc.com/us/en/issues/ifrs-reporting/publications/ifrs-and-us-gaap-similarities-and-differences.jhtml
Note the Download button!
Note that warnings are given throughout the document that the similarities and differences mentioned in the booklet are not comprehensive of all similarities and differences. The document is, however, a valuable addition to students of FASB versus IASB standard differences and similarities.

It's not easy keeping track of what's changing and how, but this publication can help. Changes for 2011 include:

• Revised introduction reflecting the current status, likely next steps, and what companies should be doing now
  (see page 2);
• Updated convergence timeline, including current proposed timing of exposure drafts, deliberations, comment periods, and final standards
  (see page 7);
• More current analysis of the differences between IFRS and US GAAP -- including an assessment of the impact embodied within the differences
  (starting on page 17); and
• Details incorporating authoritative standards and interpretive guidance issued through July 31, 2011
  (throughout).

This continues to be one of PwC's most-read publications, and we are confident the 2011 edition will further your understanding of these issues and potential next steps.

For further exploration of the similarities and differences between IFRS and US GAAP, please also visit our IFRS Video Learning Center.

To request a hard copy of this publication, please contact your PwC engagement team or contact us.

Jensen Comment
My favorite comparison topics (Derivatives and Hedging) begin on Page 158
The booklet does a good job listing differences but, in my opinion, overly downplays the importance of these differences. It may well be that IFRS is more restrictive in some areas and less restrictive in other areas to a fault. This is one topical area where IFRS becomes much too subjective such that comparisons of derivatives and hedging activities under IFRS can defeat the main purpose of "standards." The main purpose of an "accounting standard" is to lead to greater comparability of inter-company financial statements. Boo on IFRS in this topical area, especially when it comes to testing hedge effectiveness!

One key quotation is on Page 165

IFRS does not specifically discuss the methodology of applying a critical-terms match in the level of detail included within U.S. GAAP.
Then it goes yatta, yatta, yatta.

Jensen Comment
This is so typical of when IFRS fails to present the "same level of detail" and more importantly fails to provide "implementation guidance" comparable with the FASB's DIG implementation topics and illustrations.

I have a huge beef with the lack of illustrations in IFRS versus the many illustrations in U.S. GAAP.

I have a huge beef with the lack of illustrations in IFRS versus the many illustrations in U.S. GAAP.

I have a huge beef with the lack of illustrations in IFRS versus the many illustrations in U.S. GAAP.

Bob Jensen's threads on accounting standards setting controversies ---
http://faculty.trinity.edu/rjensen/Theory01.htm#MethodsForSetting

Comparisons of IFRS with Domestic Standards of Many Nations
http://www.iasplus.com/country/compare.htm

"Canadian regulator decides against allowing early adoption of recent IFRSs by certain entities," IAS Plus, November 1, 2011 ---
http://www.iasplus.com/index.htm

. . .

In making its decision, the OSFI considered a number of factors such as industry consistency, OSFI policy positions on accounting and capital, operational capacity and resource constraints of Federally Regulated Entities (FREs), the ability to benefit from improved standards arising from the financial crisis and the notion of a level playing field with other Canadian and international financial institutions. OSFI concluded that FREs should not early adopt the following new or amended IFRSs, but instead should adhere to their mandatory effective dates:

Continued

 

Jensen Comment
The clients, auditors, and the AICPA clamoring that U.S. firms should be able to voluntarily choose IFRS instead of U.S. GAAP even before it has not been decided that IFRS will ever replace FASB standards seem to ignore the problems that voluntary choice of IFRS might cause for investors and analysts. The above reasoning by the OSFI makes sense to me.

But then outfits like the AICPA have a self-serving interest in earning millions of dollars selling IFRS training courses and materials.
 

November 2, 2011 reply from Patricia Walters

Does that mean you oppose options to early adopt standards in general, not just IFRSs?

Pat

 

November 2, 2011 reply from Bob Jensen

Hi Pat,

It's hard to say regarding early adoption of a particular national or international standard, because there can be unique circumstances. For example, FAS 123R simply altered how to make disclosures rather than alter the disclosures themselves since employee option expenses had to be disclosed before the FAS 123R adoption date. But even here early adoption of FAS 123R by Company A versus late adoption by Company B made simple comparisons of eps and P/E ratios between these companies less easy.

There's a huge difference between early adoption of a particular standard and early adoption of an entire system of standards like switching from FASB accounting standards to IFRS.

I think the Canadian position of early adoption of IFRS is probably correct because of the mess early adoption of IFRS makes with comparisons of companies using different accounting standards and the added costs of regulation of more than one set of standards. Also think of the added burden placed upon the courts to adjudicate disputes when differing sets of standards are being used.

Even though we allow IFRS for SEC registered foreign companies, I think it would be a total mess for the SEC, the PCAOB, investors, analysts, educators, trainers, auditing, and even the IRS (where tax and reporting treatments must sometimes be reconciled) if our domestic corporations could choose between FASB versus IASB standards.

There are hundreds of differences between FASB and IASB standards. Allowing companies domestic companies to cherry pick which system they choose before it is even known if there will ever be official replacement of FASB standards by IASB standards would be very, very confusing. What if there never is a decision to replace FASB standards? Do want to simply allow companies to choose to bypass FASB standards at their own discretion?

Of course, if information were costless it might be ideal to require financial reporting where FASB and IASB outcomes are reconciled. But clients and auditors generally contend that the cost of doing this greatly exceeds benefits. And teaching financial accounting would become exceedingly complicated if we had to teach two sets of standards on an equal basis.

I would certainly hate to face a CPA examination that had nearly equal coverage of both FASB and IASB standards simultaneously. I say this especially after viewing the hundreds of pages of complicated differences between the two standards systems.

Respectfully,
Bob Jensen

Bob Jensen's threads on accounting standard setting controversies ---
http://www.trinity.edu/rjensen/Theory01.htm#MethodsForSetting

"Failed Convergence of R&D Accounting::  Only Politicians and Opportunists Would Have Downplayed the Implications," by Tom Selling, The Accounting Onion, June 5, 2010 --- Click Here
http://accountingonion.typepad.com/theaccountingonion/2010/06/failed-convergence-of-rd-accounting-only-politicians-and-opportunists-would-have-downplayed-the-implications.html?utm_source=feedburner&utm_medium=email&utm_campaign=Feed%3A+typepad%2Ftheaccountingonion+%28The+Accounting+Onion%29

Bob Jensen's threads on R&D accounting are at
http://faculty.trinity.edu/rjensen/Theory01.htm#FAS02

Question
Are these just dirty tricks to keep some generic drugs off the market?

Pharmaceutical makers go to great lengths to protect their exclusive marketing rights to best-selling brand-name drugs. But a pair of lawsuits and a government antitrust investigation involving a drug made by Abbott Laboratories could help define how far those companies can legally go to fend off copycat rivals.
Shirley S. Wang

From The Wall Street Journal Accounting Weekly Review on June 6, 2008

From The Wall Street Journal Accounting Educators' Review on April 23, 2004

TITLE: Brothers of Invention
REPORTER: Timothy Aeppel
DATE: Apr 19, 2004
PAGE: B1,3
LINK: http://online.wsj.com/article/0,,SB108233054158486127,00.html 
TOPICS: Research & Development, Intangible Assets

SUMMARY: Lahart reports on the growing instances of designing variations of new
patent-protected products in an attempt to skirt the patent laws and offer
virtual clones of those products at lower prices.

QUESTIONS:
1.) What is a patent? How does one appropriately account for a patent that has
been granted to a firm? How does a patent differ from other intangible assets?
How is it similar? How does a patent give a firm a competitive advantage? In
the Aeppel article, what happens to this advantage when a design-around is
introduced?

2.) Explain impairment of an intangible asset. How do the "design arounds"
described in the Aeppel article impair the value of the patent? How do you
account for such an impairment?

3.) What effect is this issue having on research & development (R&D)
expenditures for firms developing new patented products? Are R&D costs expensed
or capitalized? What about R&D costs that result in the granting of a patent?

4.) Why are valid patent-holders designing around their own products?

Reviewed By: Judy Beckman, University of Rhode Island
Reviewed By: Benson Wier, Virginia Commonwealth University 
Reviewed By: Kimberly Dunn, Florida Atlantic University

"Brothers of Invention:  'Design-Arounds' Surge As More Companies Imitate Rivals' Patented Products," by Timothy Aeppel, The Wall Street Journal, April 19, 2004, Page B1 --- http://online.wsj.com/article/0,,SB108233054158486127,00.html 

Nebraska rancher Gerald Gohl had a bright idea: Create a remote-controlled spotlight, so he wouldn't have to roll down the window of his pickup truck and stick out a hand-held beacon to look for his cattle on cold nights.

By 1997, Mr. Gohl held a patent on the RadioRay, a wireless version of his spotlight that could rotate 360 degrees and was mounted using suction cups or brackets. Retail price: more than $200. RadioRay started to catch on with ranchers, boaters, hunters and even police.

Wal-Mart Stores Inc. liked it, too. Mr. Gohl says a buyer for Wal-Mart's Sam's Club stores called to discuss carrying the RadioRay as a "wow" item, an unusual product that might attract lots of attention and sales. Mr. Gohl said no, worrying that selling to Sam's Club could drive the spotlight's price lower and poison his relationships with distributors.

Before long, though, Sam's Club was selling its own wireless, remote-controlled searchlight -- for about $60. It looked nearly identical to the RadioRay, except for a small, plastic part restricting the light's rotation to slightly less than 360 degrees. Golight Inc., Mr. Gohl's McCook, Neb., company, sued Wal-Mart in 2000, alleging patent infringement. The retailer countered that Mr. Gohl's invention was obvious and that its light wasn't an exact copy of the RadioRay's design.

The legal battle between Mr. Gohl and the world's largest retailer -- which Wal-Mart lost in a federal district court and on appeal and is now considering taking to the Supreme Court -- reflects a growing trend in the high-stakes, persnickety world of patents and product design. Patent attorneys say that companies increasingly are imitating rivals' inventions, while trying to make their own versions just different enough to avoid infringing on a patent. The near-copycat procedure, which among other things helps companies avoid paying royalties to patent holders, is called a "design-around."

"The thinking in engineering offices more and more boils down to, 'Let's see what the patent says and see if we can get around it and get something as good -- or almost as good -- without violating the patent,' " says Ken Kuffner, a patent attorney in Houston who represents a U.S. maker of retail-display stands that designed around the patent on plastic displays it used to buy from another company. He declines to identify his client.

Design-arounds are nearly as old as the patent system itself, underscoring the pressure that companies feel to keep pace with the innovations of competitors. And U.S. courts have repeatedly concluded that designing around -- and even copying products left unprotected -- can be good for consumers by lowering prices and encouraging innovation.

The practice appears to be surging as companies shift more manufacturing outside the U.S. in an effort to drive costs lower. No one tracks overall design-around numbers, but "there's really been a spike in this sort of activity in the last few years," says Jack Barufka, a patent-attorney specializing in design-arounds at Pillsbury Winthrop LLP in McLean, Va.

Mr. Barufka, a former physicist, has handled design-arounds on exercise equipment, industrial parts, and factory machinery. A client recently brought him a household appliance, which he won't identify, to be dissected part-by-part so that his client can try to make a similar product at a cheaper price, probably by using foreign suppliers.

"We design around competitor patents on a regular basis," says James O'Shaughnessy, vice president and chief intellectual property counsel at Rockwell Automation Inc. in Milwaukee, a maker of industrial automation equipment. "Anybody who is really paying attention to the patent system, who respects it, will still nevertheless try to find ways -- either offshore production or a design-around -- to produce an equivalent product that doesn't infringe."

Design-arounds are particularly common in auto parts, semiconductors and other industries with enormous markets that are attractive to newcomers looking for a way to break in. The practice also happens in mature industries, where there are few big breakthroughs and competitors rely on relatively small changes to gain a competitive advantage. Patented products are attractive targets for an attempted end run because they command premium prices, making them irresistible amid razor-thin profit margins and expanding global competition.

Few companies will talk about their design-around efforts, since the results often look like little more than clones of someone else's idea. Even companies with patented products that are designed-around usually keep quiet, sometimes because their own engineers are looking for ways to make an end run on rivals.

The surge in design-arounds is pushing research-and-development costs higher, since some companies feel forced to protect their inventions from being copied by coming up with as many alternative ways to achieve the same result -- and patenting those, too.

"A patent is basically worthless if someone else can design around it easily and make a high-performing component for less," says Morgan Chu, a patent attorney at Irell & Manella LLP in Los Angeles.

Because successful design-arounds also force prices lower, they make it harder for companies to recover their investment in new products. Danfoss AS, a Danish maker of air conditioning, heating and other industrial equipment, discovered in the late 1990s that a customer in England had switched to buying a designed-around part for a Danfoss agricultural machine at a lower price from an English supplier. Danfoss eventually won back the customer, but only after agreeing to a price concession, says Georg Nissen, the Danish company's intellectual property manager, who notes they lowered their price about 5%.

The main way for companies to fight design-arounds is in court -- or the threat of it. Dutton-Lainson Co., a Hastings, Neb., maker of marine, agricultural, and industrial products, recently discovered that a rival was selling a tool used by ranchers to tighten the barbed wire on fences that was identical to its own patented tool, with an ergonomic handle shaped to fit the palm of a hand.

Continued in the article

From The Wall Street Journal Accounting Weekly Review on October 14, 2005

TITLE: In R&D, Brains Beat Spending in Boosting Profit
REPORTER: Gary McWilliams
DATE: Oct 11, 2005
PAGE: A2
LINK: http://online.wsj.com/article/SB112898917962665021.html 
TOPICS: Financial Accounting, Financial Analysis, Financial Statement Analysis, Research & Development

SUMMARY: The article reports on a study by management consultants Booz Allen Hamilton on firms� levels of R&D spending and related performance metrics.

QUESTIONS:

1.) How must U.S. firms account for Research and Development expenditures? What is the major reasoning behind the FASB's requirement to treat these costs in this way? In your answer, reference the authoritative accounting literature promulgating this treatment and the FASB's supporting reasoning.

2.) How does the U.S. treatment differ from the treatment of R&D costs under accounting standards in effect in most countries of the world?

3.) Describe the study undertake by Booz Allen Hamilton as reported in the article. In your answer, define each of the terms for variables used in the analysis. Why would a management consulting firm undertake such a study?

4.) What were the major findings of the study? How does this finding support the FASB�s reasoning as described in answer to question 1 above?

5.) As far as you can glean from the description in the article, what are the potential weaknesses to the study? Do these weaknesses have any bearing on your opinion about the support that the results give to the current R&D accounting requirements in the U.S.? Explain.

Reviewed By: Judy Beckman, University of Rhode Island

"In R&D, Brains Beat Spending in Boosting Profit," by Gary McWilliams, The Wall Street Journal, October 11, 2005, Page A2 --- http://online.wsj.com/article/SB112898917962665021.html 

Booz Allen concluded that once a minimum level of research and development spending is achieved, better oversight and culture were more significant factors in determining financial results. The study calculated the percentage of a company's revenue spent on R&D and compared it with sales growth, gross profit, operating profit, market capitalization and total shareholder result.

It found "no statistically significant difference" when comparing the financial results of middle-of-the-pack companies with those in the top 10% of their industry, said Barry Jaruzelski, Booz Allen's vice president of Global Technology Practice. The result was the same when viewed within 10 industry groups or across all industries evaluated.

"It is the culture, the skills and the process more than the absolute amount of money available," he said. "It says tremendous results can be achieved with relatively modest amounts" of spending.

He points to Toyota Motor Corp., which spent 4.1% of revenue on R&D last year, but consistently has outperformed rivals such as Ford Motor Co., which spent 4.3% of sales on research and development. Toyota's success with hybrid, gasoline-electric cars resulted from better spending, not more spending, Mr. Jaruzelski says.

The study rankles some. Allan C. Eberhart, a professor of finance at Georgetown University, says the time period examined is too short to catch companies whose results might have benefited from past R&D spending. He co-authored a paper that found "economically significant" increases in R&D spending did benefit operating profits. The paper, which examined R&D spending at 8,000 companies over a 50-year period, found 1% to 2% increased operating profit at companies that increased R&D spending by 5% or more in a single year.

Mr. Jaruzelski said less isn't always better. The study found that companies that ranked among the bottom 10% of R&D spenders performed worse than average or top spenders. The result suggests there is a base level of research and development needed to remain healthy but that spending above a certain level doesn't confer additional benefits.

R&D spending was positively associated with one performance measure: gross margins. Median gross margins of the top half of companies measured by R&D to sales spending were 40% higher than those in the bottom half.

This is a good slide show!
"The Truth Behind the Earnings Illusion:  The profit picture has never been so distorted. The surprise? Things aren't as ugly as they look" by Justin Fox, Fortune, July 22, 2002 --- http://www.fortune.com/indexw.jhtml?channel=artcol.jhtml&doc_id=208677 

Question:  
Where are the major differences between book income and taxable income that favor booked income reported to the investing public?

Answer according to Justin Fox:

What the heck happened? The most obvious explanations for the disconnect are disparities in accounting for stock options and pension funds. When a company's employees exercise stock options, the gains are treated for tax purposes as an expense to the company but are completely ignored in reported earnings. And while investment gains made by a company's employee pension fund are counted in reported earnings, they don't show up in tax profits.

Analysts at Standard & Poor's are working to remove those two distortions by calculating a new "core earnings" measure for S&P 500 companies that includes options costs and excludes pension fund gains. When that exercise is completed in the coming weeks, most of the profit disconnect may disappear. Then again, maybe not. In struggling to deliver the outsized profits to which they and their investors had become accustomed in the mid-1990s, a lot more CEOs and CFOs may have bent the rules than we know about. "There was some cheating around the edges," says S&P chief economist David Wyss. "It's just not clear how big the edges are."

While conservative accounting is now back in vogue, it's impossible to say with certainty that reported earnings have returned to reality: Comparing the earnings per share of the S&P 500 with the tax profits of all American corporations, both public and private (which is what the Commerce Department reports), is too much of an apples and oranges exercise. But over the long run reported earnings and tax earnings do grow at about the same rate--just over 7% a year since 1960, according to Prudential Securities chief economist Richard Rippe, Wall Street's most devoted student of the Commerce Department profit numbers. So the fact that Commerce says after-tax profits came in at an annualized rate of $615 billion in the first quarter--a record-setting pace if it holds up for the full year--ought to be at least a little reassuring to investors. "I do believe the hints of recovery that we're seeing in tax profits will continue," Rippe says.

That does not mean we're due for another profit boom. Declining interest rates were the biggest reason profits rose so fast in the 1990s, says S&P's Wyss. Rates simply don't have that far to fall now. So even when investors start believing again what companies say about their earnings, they may still be shocked at how slowly those earnings are growing.

Continued at http://www.fortune.com/indexw.jhtml?channel=artcol.jhtml&doc_id=208677 

Reply by Bob Jensen:

For a technical explanation of the stock option accounting alluded to in the above quotation, go to one of my student examinations at http://www.cs.trinity.edu/~rjensen/Exams/5341sp02/exam02/Exam02VersionATeachingNotes.htm 

The exam02.xls Excel workbook answers can be downloaded from http://www.cs.trinity.edu/~rjensen/Exams/5341sp02/exam02/ 

The S&P revised GAAP core earnings model alluded to in the above quotation can be examined in greater detail at http://www.standardandpoors.com/Forum/MarketAnalysis/coreEarnings/index.html 

The pause that refreshes just got a bit more refreshing - Coca-Cola Co. announced Sunday it will lead the corporate pack by treating future stock option grants as employee compensation. http://www.accountingweb.com/item/86333

Question:
Where are the major differences between book income and economic income that understate book income reported to the investing public?

Answer:
This question is too complex to even scratch the surface in a short paragraph.  One of the main bones of contention between the FASB and technology companies is FAS 2 that requires the expensing of both research and development (R&D)  even though it is virtually certain that a great deal of the outlays for these items will have economic benefit in future years.  The FASB contends that the identification of which projects, what future periods, and the amount of the estimated benefits per period are too uncertain and subject to a high degree of accounting manipulation (book cooking) if such current expenditures are allowed to be capitalized rather than expensed.  Other bones of contention concern expenditures for building up the goodwill, reputation, and training "assets" of companies.  The FASB requires that these be expensed rather than capitalized except in the case of an acquisition of an entire company at a price that exceeds the value of tangible assets less current market value of debt.  In summary, many firms have argued for "pro forma" earnings reporting such that companies can make a case that huge expense reporting required by the FASB and GAAP can be adjusted for better matching of future revenues with past expenditures.

You can read more about these problems in the following two documents:

Accounting Theory --- http://faculty.trinity.edu/rjensen/theory.htm 

State of the Profession of Accountancy --- http://faculty.trinity.edu/rjensen/FraudConclusion.htm 

May 22, 2012 reply from Bob Jensen

Hi Marc and Paul,

The "estate valuation" analogy over simplifies the real problem of asset identification and valuation. For example, the estate of Steve Jobs most likely was a piece of cake compared to preparing a 10-K for Apple Corporation plus identifying and valuing Apple's intangible assets --- patents, copyrights, reputation, and human resources.

When valuing Apple Corporation shares owned by estate of Steve Jobs as of a given date we need only look up a table in the pages of the WSJ.

When providing accounting information to investors who make the daily market for Apple Corporation shares, the task is much more daunting.

Estate valuation is a "market taking" task. Corporate accounting is a "market making" task. This is where Baruch Lev stumbled when trying to value intangibles. He relied upon share prices to value intangibles when in fact the purpose of financial accounting is to help investors set those transaction prices. Baruch put the cart full of intangibles in front of the horse ---
http://www.trinity.edu/rjensen/theory01.htm#TheoryDisputes

Respectfully,
Bob Jensen

Hard Assets Versus Intangible Assets

Intangible assets are difficult to define because there are so many types and circumstances.  For example some have contractual or statutory lives (e.g., copyrights, patents and human resources) whereas others have indefinite lives (e.g., goodwill and intellectual capital).  Baruch Lev classifies intangibles as follows in "Accounting for Intangibles:  The New Frontier" --- http://www.nyssa.org/abstract/acct_intangibles.html :

• Spillover knowledge that creates new products and enhances value—patents, drugs, chemicals, software, etc. (i.e., Merck, Cisco, Microsoft, IBM).
• Human Resources.
• Brands/Franchises.
• Structural capital, such as processes, and systems of doing things. This is the fastest-growing group of intangibles.

He does not flesh in these groupings.  I flesh in some examples below of unbooked (unrecorded) intangible assets that may have value far in excess of all the booked assets of a company.

• Spillover Knowledge
  • Millions or billions expensed on R&D having good prospects for future economic benefit
  • Databases (e.g., prospective customer lists , knowledge bases, and AMR Sabre System)
  • Customer relationships including CRM software
  • Operational software such as Enterprise Resource Planning (ERP) installations and human resource software
  • Financial relationships such as credit reputation and  international banking contacts.
  • Production backlog
• Human Resources.
  • Highly skilled and experienced executives, staff, and labor (e.g., Steve Jobs, Bill Gates, Warren Buffet, technicians, pilots, doctors, lawyers, accountants, etc.)
  • Employee dedication and loyalty
  • Mix of discipline and creative opportunity employment structure
• Brands/Franchises.
  • Tradenames and logos
  • Patents
  • Copyrights
  • Protections from many kinds of lawsuits (e.g., road builders are not sued for every accident on roads they built and out of court settlements affording protections from future lawsuits)
• Structural Capital, Processes, and Systems
  • Machine and worker efficiencies and labor relations
  • Risk management system and ethics environment
  • Financial and operating leverage
  • TQM 
  • Supply chain management AND marketing systems (the history of Dell Corporation)
  • Political power (e.g., defense contractors, agricultural giants, and multinational oil companies)
  • Monopoly power (e.g., Microsoft corporation is worth more because there is so little competition remaining in PC operating systems and MS Office products like Excel, Word, and Powerpoint).

Mergers, Acquisitions, and Purchase Versus Pooling:  The Never Ending Debate

What's Right and What's Wrong With (SPEs), SPVs, and VIEs ---
http://faculty.trinity.edu/rjensen//theory/00overview/speOverview.htm

Advanced Accounting
Teaching case on a accounting entry has AT&T made in relation to its proposed acquisition of T-Mobile USA?

From The Wall Street Journal Weekly Accounting Review on December 2, 2011

AT&T's T-Mobile Deal Teeters
by: Anton Troianovski, Greg Bensinger and Amy Schatz
Nov 25, 2011
Click here to view the full article on WSJ.com
 

TOPICS: Contingent Liabilities

SUMMARY: 'AT&T and Deutsche Telekom insisted they weren't throwing in the towel" on their proposed transaction for AT&T to acquire T-Mobile, Deutsche Telekom's U.S. cellular phone operation. However, AT&T announced it would take a charge in the fourth quarter's financial statements for a $4 billion break-up fee it agreed to in negotiations.

CLASSROOM APPLICATION: Accounting for contingent liabilities and the link to information being signaled to the market is the focus of this review.

QUESTIONS: 
1. (Introductory) What accounting entry has AT&T made in relation to its proposed acquisition of T-Mobile USA? When will this entry impact AT&T's reported results?

2. (Advanced) What accounting standard requires making this entry?

3. (Introductory) Access the filing made by AT&T to the SEC regarding this matter. It is available on the SEC web site at http://www.sec.gov/Archives/edgar/data/732717/000073271711000097/tmobile.htm. Why do you think the company must make this disclosure at this time?

4. (Advanced) How does the accounting for this $4 billion become a signal that the AT&T planned acquisition of T-Mobile "is more likely to fail than to succeed"?
 

Reviewed By: Judy Beckman, University of Rhode Island
 

RELATED ARTICLES: 
Nuggets from the FCC's Scathing Report on AT&T/T-Mobile
by Anton Troianovski
Nov 30, 2011
Online Exclusive

 

"AT&T's T-Mobile Deal Teeters," by: Anton Troianovski, Greg Bensinger and Amy Schatz, The Wall Street Journal, November 25, 2011 ---
http://online.wsj.com/article/SB10001424052970204452104577057482069627186.html?mod=djem_jiewr_AC_domainid

AT&T Inc. signaled for the first time that its planned $39 billion acquisition of T-Mobile USA is more likely to fail than to succeed, saying Thursday it would set aside $4 billion in this year's final quarter to cover the potential cost of the deal falling apart.

The move came after Federal Communications Commission Chairman Julius Genachowski said this week he would seek a rare, trial-like hearing on the merger, which would add months of arguments and another big hurdle for the controversial deal.

AT&T and T-Mobile parent Deutsche Telekom AG responded Thursday morning by pulling their application for merger approval at the FCC in order to focus on their fight with the Justice Department, which has sued to block the acquisition.

The federal agencies say a deal combining the No. 2 and No. 4 wireless carriers would damage competition and potentially raise prices, with little offsetting benefit. AT&T needs both agencies to sign off to get the merger through.

The moves, disclosed in the early hours of Thanksgiving morning in the U.S. and just ahead of the market's opening in Germany, reflect a changed internal calculus at AT&T about the deal's chances to succeed.

AT&T and Deutsche Telekom insisted they weren't throwing in the towel. Their strategy is to try to strike a settlement with the Justice Department or to beat the agency in a trial that begins Feb. 13, then reapply with the FCC for merger approval.

But it was clear that the odds have lengthened significantly for a deal that would have created the country's largest wireless operator. "There's a degree of giving up," said Bernstein Research analyst Robin Bienenstock. "If you believed you could litigate your way out of it or do something else, you wouldn't take the charge."

The developments could mean many more months of uncertainty for the wireless industry and for consumers, particularly T-Mobile's 33.7 million customers. T-Mobile has lost 850,000 contract customers this year, and it failed to land the most sought-after device, Apple Inc.'s iPhone. If the AT&T deal falls through, analysts and investors expect Deutsche Telekom to try to find another way to exit the U.S. market.

A broken deal would send AT&T back to the drawing board for a strategy to shore up its network and compete with larger rival Verizon Wireless. AT&T has said it needs to buy T-Mobile to gain much-needed rights to the airwaves. It also sees the deal as an expeditious way to shore up its network, which has come under strain from the demands of millions of iPhones and other devices, hurting call quality and prompting customer complaints.

Justice Department officials were taking stock of the developments but expected to continue preparing for trial, a person familiar with the matter said. AT&T's move has increased the certainty felt by many department officials that the company is unlikely to prevail in court, this person said. A Justice Department spokesperson couldn't be reached for comment.

For AT&T Chief Executive Officer Randall Stephenson, the merger with T-Mobile represents the biggest gamble in a four-year tenure that has been devoid of blockbuster deals, which were a hallmark of his predecessor, Ed Whitacre. Mr. Whitacre created today's AT&T over more than a decade of deal-making that pieced together fragments of Ma Bell and rolled up several wireless companies.

Analysts had generally considered AT&T to be too big to pull off any more mergers in the U.S. In order to persuade Deutsche Telekom to go along, AT&T agreed to pay $3 billion in cash, and to turn over valuable spectrum if the merger fell through, an unusually large breakup fee.

For AT&T, the benefits of the deal are potentially huge. T-Mobile, which uses the same network technology as AT&T, seemed to be the answer to network constraints. Heavy overlap meant cost savings could be huge. The deal would vault AT&T ahead of rival Verizon Wireless.

AT&T, which announced the deal on March 20, said buying T-Mobile would allow it to extend its high-speed mobile network into more of rural America, striking a chord in Washington. AT&T lined up supporters among governors, members of Congress and interest groups.

Yet AT&T apparently failed to anticipate antitrust officials' concerns about growing market concentration in the wireless industry, already dominated by Verizon Wireless and AT&T.

On the morning of Aug. 31, Mr. Stephenson touted the deal on CNBC. Later that day, the Justice Department filed suit to block it on antitrust grounds.

Continued in article

 

Teaching Case from The Wall Street Journal Accounting Weekly Review on October 5, 2012

T-Mobile Redials America
by: Miriam Gottfried
Oct 03, 2012
Click here to view the full article on WSJ.com
 

TOPICS: Antitrust, business combinations, Mergers and Acquisitions

SUMMARY: In 2011, Deutsche Telekom had planned to stop investing in its U.S. cellular operation, T-Mobile USA, and sell the company to AT&T. However, that combination was stopped by the Justice Department for anti-trust reasons. Deutsche Telekom now has announced a plan for T-Mobile USA to merge with MetroPCS.

CLASSROOM APPLICATION: The article is useful to introduce the process of business combinations in advance of teaching the accounting for these transactions. The related article describes the accounting entry made by AT&T to record a charge for the break-up fee associated with its attempted combination with T-Mobile, clearly indicating likely failure of the transaction.

QUESTIONS: 
1. (Introductory) What are the competitive and strategic reasons that form the "...many ways it actually makes sense for T-Mobile's parent, Deutsche Telekom, to bulk up in the U.S. with the deal"?

2. (Advanced) What are the historical reasons to indicate that this deal may face trouble amounting to "continuing to dig when you're in a hole"? Refer to the related article to assist in your answer.

3. (Advanced) What form of business combination and "currency" for the business combination does the author think is likely? What financing reasons lead to this conclusion?

4. (Advanced) What is a "reverse merger"? How would that result in Deutsche Telekom having a U.S. stock listing?
 

Reviewed By: Judy Beckman, University of Rhode Island
 

RELATED ARTICLES: 
AT&T's T-Mobile Deal Teeters
by Anton Troianovski, Greg Bensinger and Amy Schatz
Nov 25, 2011
Page: A1

 

"T-Mobile Redials America," by Miriam Gottfried, The Wall Street Journal, October 3, 2012 ---
http://professional.wsj.com/article/SB10000872396390443862604578032873818844376.html?mod=djem_jiewr_AC_domainid&mg=reno64-wsj

When you are in a hole, you usually stop digging. And yet struggling T-Mobile USA, after failing to sell itself to AT&T, T +0.44% may be about to dig even deeper into the U.S. market: It is in talks to purchase prepaid mobile carrier MetroPCS PCS +3.55% .

In many ways, it actually makes sense for T-Mobile's parent, Deutsche Telekom, DTE.XE +1.49% to bulk up in the U.S. with the deal. It would eliminate a low-cost competitor and give the combined companies 29.5% of the prepaid market, according to Sanford C. Bernstein. Total subscribers would be 42.5 million, against 56 million for Sprint, S -2.16% 111 million for Verizon Wireless VZ +2.07% and 105 million for AT&T, as of the second quarter.

If T-Mobile were to structure the deal as a reverse merger, as some analysts have suggested, it would give the company a U.S. stock listing. That would allow it to finance itself separately and let Deutsche Telekom sell down its exposure over time. MetroPCS's spectrum holdings are geographically complementary with T-Mobile's. And a deal would significantly bolster the latter's presence in the top 100 markets, as well as giving it crucial bandwidth to build a next-generation LTE network.

Given future calls on T-Mobile's cash—from integration expenses, network investment and the possible introduction of the iPhone on its network—any deal is likely to be in stock. MetroPCS shareholders would potentially own about one-quarter of the combined company.

One key opportunity is for T-Mobile to move subscribers off MetroPCS's network, which uses a different technology, and eventually to turn it off. That would both free up spectrum and allow the combined company to save money by merging cell sites, among other things.

But it can be a painful process as evidenced by Sprint's ongoing shutdown of the Nextel network, which it bought in 2005. Running both networks for so long has squeezed Sprint's margins. Sprint expects the transition—which includes the cost of lost subscribers, in addition to other expenses related to shutting down the network—to reduce profit by $800 million in 2012 and by another $100 million in 2013.

T-Mobile will also be able to build a single LTE network, although it will still have to spend billions that it would have saved if the sale to AT&T hadn't been blocked by regulators on competition grounds. The deal probably has little impact on T-Mobile's decision on whether or not to offer the iPhone to better compete against AT&T and Verizon Wireless. But UBS expects it to begin carrying the iPhone next year, meaning hefty subsidy costs, particularly for postpaid subscribers who pick the device.

If the deal goes through, the most obvious loser is Sprint, which was widely seen as the most likely buyer for MetroPCS or T-Mobile. In addition to being a sign that T-Mobile is prepared to invest in its business, at least for now, the deal could make regulators less likely to welcome any Sprint-T-Mobile tie-up in the future.

Continued in article

Teaching Case
From The Wall Street Journal Accounting Weekly Review on December 10, 2010

Beauty of the Deal: Coty Seeks China Firm
by: Ellen Byron and Dana Cimilluca
Dec 04, 2010
Click here to view the full article on WSJ.com

TOPICS: Investments, Mergers and Acquisitions
SUMMARY: "Coty Inc. is nearing a deal to buy Chinese skin-care company TJOY...in what would cap a three-week acquisition binge led by CEO Bernd Beetz at the closely held fragrance giant." Coty also recently "...agreed to buy skin-care brand Philosophy Inc. [for a value of about]...$1 billion" and in November announced "...a planned purchase of nail-polish maker OPI Products Inc. in a deal people familiar with the matter [also] valued near $1 billion."

CLASSROOM APPLICATION: The article is useful to introduce corporate strategies executed through business combinations particularly for an advanced financial accounting class on consolidations. The product should be of interest to students (at least approximately half of them!) and it is useful to show M&A activity by a closely-held corporation.

QUESTIONS:
1. (Introductory) List all of the acquisitions Coty has made in the past several weeks. Why is the company able to make so many purchases now?

2. (Introductory) What overall corporate strategy is the company executing with these purchases?

3. (Advanced) How would you classify these acquisitions: vertical integration, horizontal merger/acquisition, or conglomerate?

4. (Advanced) What specific synergies does Coty expect to obtain from the acquisition of Chinese skin-care company TJOY?

5. (Introductory) How is Coty paying for its acquisition of TJOY?

6. (Advanced) "As with all such deals, this one could still fall apart." Why?

7. (Advanced) Coty is a privately held firm. How is the WSJ able to obtain information about its acquisition? Why are WSJ readers interested in this information if they cannot become investors in Coty?

Reviewed By: Judy Beckman, University of Rhode Island

"Beauty of the Deal:  Coty Seeks China Firm," by: Ellen Byron and Dana Cimilluca, The Wall Street Journal, December 4, 2010 ---
http://online.wsj.com/article/SB10001424052748704526504575634932200517748.html?mod=djem_jiewr_AC_domainid

Coty Inc. is nearing a deal to buy Chinese skin-care company TJOY, people familiar with the matter said, in what would cap a three-week acquisition binge led by CEO Bernd Beetz at the closely held fragrance giant.

Mr. Beetz is trying to remake one of the world's biggest fragrance makers into a diversified beauty company. In November, it announced three major deals, most recently a planned purchase of nail-polish maker OPI Products Inc. in a deal people familiar with the matter valued near $1 billion.

It also agreed to buy skin-care brand Philosophy Inc., which people close to the deal also valued around $1 billion, and disclosed plans to buy German beauty firm Dr. Scheller Cosmetics AG for an undisclosed sum.

Coty is planning to announce the TJOY deal Sunday or Monday, according to the people familiar. The cash-and-stock deal values the closely held Chinese company at about $400 million. As with all such deals, this one could still fall apart.

Buying TJOY, which offers men's and women's skin care products, would give Coty access to an array of well-known brands and distribution in the fast-growing Chinese market. Although the deal is small by Western standards, it will be a relatively large deal in China, which has proven challenging for many Western companies to penetrate.

Mr. Beetz, a 60-year-old German native who has led Coty since 2001, is rapidly expanding into skin care and makeup as the fragrance industry continues to struggle. Last year, global sales of premium fragrances totaled $20.3 billion, down 6.5% from the year before, according to market-research firm Euromonitor International Inc.

Heading into the crucial holiday season, when the majority of fragrance sales happen each year, Mr. Beetz is betting that an emphasis on new celebrity fragrances and some classics will win over hesitant shoppers.

Coty, which makes fragrances under celebrity names including Jennifer Lopez and David Beckham and designer labels such as Calvin Klein, as well as Sally Hansen nail polish and N.Y.C. New York Color cosmetics, posted sales of $3.6 billion in its fiscal year that ended June 30. Mr. Beetz recently spoke with The Wall Street Journal.

Excerpts:

WSJ: You've been a busy deal-maker. What's motivating your shopping spree?

Mr. Beetz: We're doing very well right now, so I think it's a good time to use the momentum to further execute our strategy. We always said we wanted three pillars: fragrances, color cosmetics and skin care.

WSJ: Rumors of Coty doing an IPO have circled for years. Do you want to go public?

Mr. Beetz: We have no immediate plans but we'd never exclude that.

WSJ: What's your strategy for navigating the holiday season?

Mr. Beetz: I sense less uncertainty. I expect shoppers to buy at least what they did last year, though I think it's going to be better.

WSJ: How has the mindset of the luxury consumer changed during the recession?

Mr. Beetz: I don't think the basic mindset has changed. There is a certain compromising during the crisis, so there is some trading down or pausing with purchases, but the basic attitude hasn't changed. This consumer wants to indulge themselves and reward themselves with a piece of luxury. It can be a handbag or a nice lipstick or a perfume. We benefit from it right now.

WSJ: In recent years fragrance has been among the worst performing categories in beauty. Can manufacturers do something differently to boost the business?

Mr. Beetz: Not fundamentally. I think it is a business very much driven by trends, so you have to be even closer than ever before to the marketplace. It's also helpful to have bigger projects with a bigger focus and fewer launches. Big blockbusters also help the business. You have to keep entertaining the consumer.

WSJ: You had mapped 2010 to be the year you hit $5 billion in sales. That didn't happen. What's your outlook now?

Mr. Beetz: We would have been there without the big global crisis. Overall, we have a big sense of accomplishment, because all the key measurements we put in place worked out.

We have a new roadmap to 2015. We have grown in the last nine years, with average revenue growth of 15%. It's true that the crisis was a bit of a pause, but we overcame that and are back on track.

WSJ: Where do you see sales potential for Coty?

Mr. Beetz: We see growth opportunities in established markets and in emerging markets. There are still major opportunities in developed markets, for example central Europe is doing very well right now. Eastern Europe is back. We have major upside in Asia. We also see major growth opportunities in the U.S. in department stores, especially with our prestige fragrance portfolio. I think we can gain even more market share there.

WSJ: Naysayers say the popularity of celebrity fragrances is waning. What do you think?

Mr. Beetz: I never shared this point of view. Right now I am particularly encouraged with the success we are having with Beyoncé and Halle Berry, and I think we'll have a major success with Lady Gaga next year. The category is very much alive with the right project.

Continued in article

Bob Jensen's threads on mergers ---
http://faculty.trinity.edu/rjensen/Theory01.htm#Pooling

Comparisons of IFRS with Domestic Standards of Many Nations
http://www.iasplus.com/country/compare.htm

More Detailed Differences (Comparisons) between FASB and IASB Accounting Standards

2011 Update

"IFRS and US GAAP: Similarities and Differences" according to PwC (2011 Edition)
http://www.pwc.com/us/en/issues/ifrs-reporting/publications/ifrs-and-us-gaap-similarities-and-differences.jhtml
Note the Download button!
Note that warnings are given throughout the document that the similarities and differences mentioned in the booklet are not comprehensive of all similarities and differences. The document is, however, a valuable addition to students of FASB versus IASB standard differences and similarities.

It's not easy keeping track of what's changing and how, but this publication can help. Changes for 2011 include:

• Revised introduction reflecting the current status, likely next steps, and what companies should be doing now
  (see page 2);
• Updated convergence timeline, including current proposed timing of exposure drafts, deliberations, comment periods, and final standards
  (see page 7);
• More current analysis of the differences between IFRS and US GAAP -- including an assessment of the impact embodied within the differences
  (starting on page 17); and
• Details incorporating authoritative standards and interpretive guidance issued through July 31, 2011
  (throughout).

This continues to be one of PwC's most-read publications, and we are confident the 2011 edition will further your understanding of these issues and potential next steps.

For further exploration of the similarities and differences between IFRS and US GAAP, please also visit our IFRS Video Learning Center.

To request a hard copy of this publication, please contact your PwC engagement team or contact us.

Jensen Comment
My favorite comparison topics (Derivatives and Hedging) begin on Page 158
The booklet does a good job listing differences but, in my opinion, overly downplays the importance of these differences. It may well be that IFRS is more restrictive in some areas and less restrictive in other areas to a fault. This is one topical area where IFRS becomes much too subjective such that comparisons of derivatives and hedging activities under IFRS can defeat the main purpose of "standards." The main purpose of an "accounting standard" is to lead to greater comparability of inter-company financial statements. Boo on IFRS in this topical area, especially when it comes to testing hedge effectiveness!

One key quotation is on Page 165

IFRS does not specifically discuss the methodology of applying a critical-terms match in the level of detail included within U.S. GAAP.
Then it goes yatta, yatta, yatta.

Jensen Comment
This is so typical of when IFRS fails to present the "same level of detail" and more importantly fails to provide "implementation guidance" comparable with the FASB's DIG implementation topics and illustrations.

I have a huge beef with the lack of illustrations in IFRS versus the many illustrations in U.S. GAAP.

I have a huge beef with the lack of illustrations in IFRS versus the many illustrations in U.S. GAAP.

I have a huge beef with the lack of illustrations in IFRS versus the many illustrations in U.S. GAAP.

Bob Jensen's threads on accounting standards setting controversies ---
http://faculty.trinity.edu/rjensen/Theory01.htm#MethodsForSetting

Comparisons of IFRS with Domestic Standards of Many Nations
http://www.iasplus.com/country/compare.htm

"Canadian regulator decides against allowing early adoption of recent IFRSs by certain entities," IAS Plus, November 1, 2011 ---
http://www.iasplus.com/index.htm

. . .

In making its decision, the OSFI considered a number of factors such as industry consistency, OSFI policy positions on accounting and capital, operational capacity and resource constraints of Federally Regulated Entities (FREs), the ability to benefit from improved standards arising from the financial crisis and the notion of a level playing field with other Canadian and international financial institutions. OSFI concluded that FREs should not early adopt the following new or amended IFRSs, but instead should adhere to their mandatory effective dates:

Continued

 

Jensen Comment
The clients, auditors, and the AICPA clamoring that U.S. firms should be able to voluntarily choose IFRS instead of U.S. GAAP even before it has not been decided that IFRS will ever replace FASB standards seem to ignore the problems that voluntary choice of IFRS might cause for investors and analysts. The above reasoning by the OSFI makes sense to me.

But then outfits like the AICPA have a self-serving interest in earning millions of dollars selling IFRS training courses and materials.
 

November 2, 2011 reply from Patricia Walters

Does that mean you oppose options to early adopt standards in general, not just IFRSs?

Pat

 

November 2, 2011 reply from Bob Jensen

Hi Pat,

It's hard to say regarding early adoption of a particular national or international standard, because there can be unique circumstances. For example, FAS 123R simply altered how to make disclosures rather than alter the disclosures themselves since employee option expenses had to be disclosed before the FAS 123R adoption date. But even here early adoption of FAS 123R by Company A versus late adoption by Company B made simple comparisons of eps and P/E ratios between these companies less easy.

There's a huge difference between early adoption of a particular standard and early adoption of an entire system of standards like switching from FASB accounting standards to IFRS.

I think the Canadian position of early adoption of IFRS is probably correct because of the mess early adoption of IFRS makes with comparisons of companies using different accounting standards and the added costs of regulation of more than one set of standards. Also think of the added burden placed upon the courts to adjudicate disputes when differing sets of standards are being used.

Even though we allow IFRS for SEC registered foreign companies, I think it would be a total mess for the SEC, the PCAOB, investors, analysts, educators, trainers, auditing, and even the IRS (where tax and reporting treatments must sometimes be reconciled) if our domestic corporations could choose between FASB versus IASB standards.

There are hundreds of differences between FASB and IASB standards. Allowing companies domestic companies to cherry pick which system they choose before it is even known if there will ever be official replacement of FASB standards by IASB standards would be very, very confusing. What if there never is a decision to replace FASB standards? Do want to simply allow companies to choose to bypass FASB standards at their own discretion?

Of course, if information were costless it might be ideal to require financial reporting where FASB and IASB outcomes are reconciled. But clients and auditors generally contend that the cost of doing this greatly exceeds benefits. And teaching financial accounting would become exceedingly complicated if we had to teach two sets of standards on an equal basis.

I would certainly hate to face a CPA examination that had nearly equal coverage of both FASB and IASB standards simultaneously. I say this especially after viewing the hundreds of pages of complicated differences between the two standards systems.

Respectfully,
Bob Jensen

Bob Jensen's threads on accounting standard setting controversies ---
http://www.trinity.edu/rjensen/Theory01.htm#MethodsForSetting

"General Mills Nears $1.1 Billion Deal to Buy Half of Yoplait," by Chris V. Nicholson, The New York Times, March 18, 2011 ---
http://dealbook.nytimes.com/2011/03/18/general-mills-set-to-buy-yoplait-stake-for-1-1-billion/?nl=business&emc=dlbka9

From The Wall Street Journal Accounting Weekly Review on May 13, 2011

Microsoft Dials Up Change
by: Nick Wingfield
May 11, 2011
Click here to view the full article on WSJ.com
Click here to view the video on WSJ.com 
 

TOPICS: Mergers and Acquisitions

SUMMARY: "Microsoft made an unsolicited bid for the Internet company last month and clinched its deal late Monday...." The price, including taking responsibility for Skype's outstanding debt, totals $8.4 billion.

CLASSROOM APPLICATION: The article is useful for introducing business combinations but also includes discussion of EBITDA and operating profit versus net income as well as the fact that the cash Microsoft will use otherwise might stay overseas and be unavailable for investment. Microsoft has most of its huge cash balance held in overseas locations and would be subject to repatriated earnings tax in order to get access to it.

QUESTIONS: 
1. (Introductory) What was the Microsoft stock price reaction to this announcement that it will buy Skype?

2. (Introductory) What are two questions about the value of this investment to Microsoft? In your answer, address the question of how Microsoft can justify a purchase price of $8.5 billion when the company is not making a profit.

3. (Advanced) Skype is "EBITDA positive but doesn't have net income," says Nick Wingfield, a WSJ Reporter, on the related video. What does this statement mean?

4. (Advanced) Why might Skype have operating profit but not net income? In your answer, define these two financial terms.

5. (Advanced) Skype's previous owner, EBay Inc., "...bought Skype in 2005 for around $3.1 billion but took a $1.4 billion charge for the transaction in 2007 after it failed to produce hoped-for synergies." What type of a write down do you think this was? Why does this write down have implications for the current Microsoft purchase?

6. (Introductory) Where is the cash that Microsoft will use to make this purchase? Why is the cash not available to Microsoft in the U.S.? How might the tax implication of using that cash impact the price Microsoft would be willing to pay for Skype?
 

Reviewed By: Judy Beckman, University of Rhode Island
 

RELATED ARTICLES: 
Microsoft's Pricey Call on Skype
by Martin Peers
May 11, 2011
Page: C20

 

"Microsoft Dials Up Change," by: Nick Wingfield, The Wall Street Journal, May 13, 2011 ---
http://online.wsj.com/article/SB10001424052748703730804576314854222820260.html?mod=djem_jiewr_AC_domainid

Microsoft Corp. racked up a whopping $8.5 billion phone bill to buy Skype SARL even though there were no signs of other serious bidders for the provider of free online video and voice chats, as the software giant moved aggressively to ramp up its growth.

Microsoft made an unsolicited bid for the Internet company last month and clinched its deal late Monday, nixing a planned Skype public offering and short-circuiting any talks with competitors such as Google Inc. and Facebook Inc.

Steve Ballmer, Microsoft's chief executive, defended the price in an interview, saying the deal—the biggest in his company's 36-year history—will let Microsoft "be more ambitious, do more things."

While Facebook, Google and Cisco Systems Inc. had shown interest in Skype, Microsoft was by far the most determined buyer, people familiar with the matter said.

The price tag—three times what Skype fetched 18 months ago—is a sign of just how hungry Microsoft is for growth opportunities—especially in the mobile-phone and Internet markets. Those missed opportunities are increasingly worrisome to Microsoft investors as traditional profit engines, like its Windows software, are showing signs of slowing.

The Skype deal is a gamble by Mr. Ballmer that he can succeed where those that have gone before him have failed: using the phone-and-video-calling service to make money. Microsoft's ambitious goal is to integrate Skype into everything from its Xbox videogame console to its Office software suite for businesses.

Microsoft also hopes Skype can jump-start its effort to turn around its fortunes in the mobile-phone market, an area where it has lagged far behind Apple Inc. and Google. Phones running Microsoft software were just 7.5% of the smartphone market last quarter, according to Comscore Inc.

he Skype purchase comes as the technology industry's momentum is increasingly being fueled by consumers, with the explosive rise of social network Facebook, now at more than 600 million global members, and devices such as Apple's iPad and iPhone reshaping the cellphone and computer markets.

That has pushed many big tech companies that had largely relied on businesses for growth—from Dell Inc. to Cisco—to seek ways into consumer technologies.

Some of those moves haven't paid off, however. Cisco, for example, recently shut down the division that made its Flip video cameras, just two years after acquiring the business.

Whether Microsoft can make a Skype acquisition work—especially at such a rich price—is a question mark. EBay Inc. bought Skype in 2005 for around $3.1 billion but took a $1.4 billion charge for the transaction in 2007 after it failed to produce hoped-for synergies.

EBay decided to shed the business, and sold a 70% stake in Skype to a group of investors led by private-equity firm Silver Lake Partners about 18 months ago. The deal valued all of Skype at a $2.75 billion.

Mr. Ballmer said Microsoft and Skype have far more in common than Skype had with eBay since both companies are in the "communications business." He said communications technologies have been "the backbone" of Microsoft's growth in recent years and that Skype has "built a real business," with more than $860 million in 2010 revenue.

"I think our case for why to bring this together comes from a very different place," he said.

Overall, Skype has more than 170 million active users and 207 billion minutes of voice and video conservations flowing through its service. But despite its widespread use, it has been slow to convert users into paying customers and generate meaningful profits. It had a net loss of $7 million last year.

Continued in article

Two Mergers and Acquisitions Cases
From The Wall Street Journal Accounting Weekly Review on February 18, 2011

Investors Warm to Big Deals
by: Anupreeta Das and Gina Chon
Feb 11, 2011
Click here to view the full article on WSJ.com
 

TOPICS: Mergers and Acquisitions, Stock Price Effects

SUMMARY: Worldwide mergers & acquisition activity totals $338 billion so far in 2011, "...a rate 25% higher than in the same period last year. And in the U.S., deal volume is more than double last year's rate, which makes 2011 the most active since 2008." M&A deals this year also are larger--with 12 deals worldwide, 8 in the U.S., above $5 billion-and are focused on consolidation "mostly in coal-mining, utilities and exchange companies." One unusual factor this year: not only are target firm share prices reacting positively to the transactions, but so are acquiring firms' share prices. Acquirers usually see their share prices fall as shareholders expect virtually all of the gains from business combinations to be paid out to target firm shareholders.

CLASSROOM APPLICATION: The article is useful to introduce general topics related to mergers and acquisitions, typically done in an Advanced Accounting class prior to teaching consolidation accounting.The general tone of the article also makes it useful for an MBA class.

QUESTIONS: 
1. (Introductory) Summarize the current state of mergers and acquisitions activity in 2011 compared to recent years.

2. (Introductory) What does this M&A activity indicate about corporate CEO confidence in the overall U.S./North American economy? Hint: you may also refer to discussion in the related video to answer this question.

3. (Advanced) "...The deals have had little sizzle, serving to consolidate mostly coal-mining, utilities and exchange companies." What does the term "consolidate" mean in this context?

4. (Advanced) How to acquiring firm and target firm share prices typically react to merger and acquisition announcements? How is that reaction measured? What is different about shareholder reaction to 2011 M&A activity?

5. (Advanced) How do "low interest rates" lead companies "back in the M&A game"?
 

Reviewed By: Judy Beckman, University of Rhode Island
 

---

Sanofi, Genzyme May Announce Deal Wednesday
by: Gina Chon and Jonathan D. Rockoff
Feb 16, 2011
Click here to view the full article on WSJ.com
 

TOPICS: Mergers and Acquisitions

SUMMARY: On Wednesday, February 17, 2011, Sanofi-Aventis and Genzyme announced that they had reached a deal for acquisition of Genzyme. The companies' boards agreed to a cash deal of about $19 billion plus contingent payments, leading the total to over $20 billion. "Now comes the hard part: making the marriage work."

CLASSROOM APPLICATION: The primary and related articles list factors to be considered that may inhibit success of an acquisition useful in introducing business combinations in an advanced financial accounting class or an MBA class.

QUESTIONS: 
1. (Introductory) Summarize this acquisition transaction. What is the strategic purpose behind the transaction? What is the consideration being paid, and to whom is it being paid?

2. (Advanced) Describe the process of negotiations culminating in the deal announcement described in this article. In your answer, define the phrase hostile takeover.

3. (Advanced) Categorize this acquisition as either vertical, horizontal, or conglomerate. Support your assessment.

4. (Introductory) What pitfalls have beset acquisitions in the pharmaceutical industry? What factors indicate whether or not this business combination might face similar difficulties?

5. (Introductory) What are contingent payments in an acquisition? What purpose do they serve in this deal for Sanofi-Aventis to acquire Genzyme?
 

Reviewed By: Judy Beckman, University of Rhode Island

"Investors Warm to Big Deals," by: Anupreeta Das and Gina Chon, The Wall Street Journal, February 11, 2011 ---
http://online.wsj.com/article/SB10001424052748704132204576136553233927870.html?mod=djem_jiewr_AC_domainid

The big takeover deal has come back, reflecting increased corporate confidence and economic recovery. What should hearten prospective deal makers is how the stock market has reacted to the transactions: It has loved them.

Across the globe, deal volume stands at $338 billion so far this year, a rate 25% higher than in the same period last year. And in the U.S., deal volume is more than double last year's rate, which makes 2011 the most active since 2008.

The deals are getting bigger, too. In 2011, there have been 12 deals valued above $5 billion, eight of them in the U.S., according to Dealogic. There were only two such deals in the U.S. at the same time last year.

For all their size, the deals have had little sizzle, serving to consolidate mostly coal-mining, utilities and exchange companies. There was Alpha Natural Resources Inc.'s $7.1 billion deal to buy Massey Energy Co., a $13.7 billion merger of utility companies Duke Energy Corp. and Progress Energy Inc., and this week, the planned deal between London Stock Exchange Group PLC and Canada's TMX Group Inc., the company that owns the Toronto and Montreal exchanges.

One of the big differences from past merger run-ups: Investors are sending the acquirers' stock prices up, not down, after the deals are made public.

Shares of iron-ore producer Cliffs Natural Resources Inc. rose nearly 3% on Jan. 11 after it announced a deal for rival iron-ore producer Consolidated Thompson Iron Mines Ltd. for about $5 billion.

On Monday, Danaher Corp. agreed to pay $5.87 billion for Beckman Coulter Inc., which makes diagnostic equipment used in medical testing. Danaher is paying a 45% premium on Beckman shares, usually a sum that sparks acquiring-company shareholders to fear the company is spending too much. But Danaher stock rose on the news, as investors cheered the industrial conglomerate's move into a new, high-growth sector of life sciences. Swelling middle-class populations in emerging markets such as China and India are expected to drive demand for preventive medical care, of which clinical testing is a central feature.

Deutsche Bank analyst Nigel Coe called the deal "strategically coherent" and said the low cost of financing the deal, given the state of credit markets right now, will add more to Danaher's earnings.

Wall Street has welcomed these deals because many of these industries were ripe for consolidation before the recession, but deal-making was put on hold as the debt markets shut down and companies preferred to hold on to their cash.

For instance, Deutsche Börse AG and NYSE Euronext talked seriously about a deal in 2008 and 2009, but the fragile global economy discouraged a cross-border merger. The two are now close to a tie-up to form a company with a putative market value of $25 billion, and a deal could be sealed next week. The Big Board's stock shot up as much as 18% on news of the latest talks, which followed Tuesday's merger news between the owners of the London and Toronto exchanges. Shares of those companies climbed 9% and 4%, respectively.

"We saw a time period in 2009 and even in early 2010 when CEOs were primarily focused on tactical opportunities, but today they're focused more on strategic opportunities," said Jack MacDonald, co-head of Americas M&A at Bank of America Merrill Lynch.

Danaher, for instance, has had its eye on diagnostics companies for years. It was a confluence of factors, including the improving economy, with "headwinds dissipating, tailwinds getting stronger," that helped it seal a deal for Beckman, Danaher Chief Executive Lawrence Culp said in an interview Monday.

Low interest rates, strong corporate performance in 2010 and a sense that the global economy is moving forward have put companies "back in the M&A game," he added.

Continued in article

"Sanofi, Genzyme May Announce Deal Wednesday," by: Gina Chon and Jonathan D. Rockoff, The Wall Street Journal, February 16, 2011 ---
http://online.wsj.com/article/SB10001424052748704409004576146350470325700.html?mod=djem_jiewr_AC_domainid

Sanofi-Aventis SA is expected to acquire Genzyme Corp. for about $19 billion in cash, plus possible additional payments in the future, in a deal that could be announced as soon as Wednesday, people familiar with the matter said.

After Sanofi initially considered trying to obtain a slightly lower price, the parties largely agreed to the broad terms that they originally negotiated when Sanofi was given access to Genzyme's financial books on Jan. 31, these people said.

Talks are continuing and final details are still being worked out, these people added. The boards of both companies were meeting Tuesday and an announcement could come in the morning European time, ahead of Genzyme's earnings announcement.

As part of that broad agreement, Sanofi agreed to raise its offer from $69 a share to about $74 a share in cash, or about $19 billion, people familiar with the matter said.

Genzyme investors also would receive a so-called contingent value right, or CVR, that would entitle them to additional payments if the company meets certain sales goals. The CVR, which investors would be able to trade on a stock exchange, would have an initial trading value of at least $2 a share, people familiar with the matter said.

After Sanofi finished its due diligence on Genzyme, Sanofi executives pushed to change some of the original terms, and therefore some of the criteria for the CVR have been adjusted, these people added. Details of the terms of the CVR are still being finalized, they said.

The CVR would have an eventual value of between $5 and $6 a share if Genzyme meets sales targets for a drug used to treat leukemia, which is also being tested against multiple sclerosis. The future payments could be worth as much as $14 a share over the long term in the best-case scenario for sales of the drug to multiple-sclerosis patients, according to people familiar with the matter.

Sanofi didn't find any major issues in its examination of Genzyme's financial books and manufacturing facilities. There was a risk for Genzyme that Sanofi could discover some problems, given that the Cambridge, Mass., biotechnology firm is still recovering from manufacturing issues that temporarily shut down a Genzyme production facility in 2009.

A CVR is often used when parties can't agree on price. One of the issues between Sanofi and Genzyme is their differing predictions on the sale of the multiple-sclerosis drug. Genzyme has predicted those sales could reach $3.5 billion in 2017, a projection Sanofi has said is too optimistic.

Sanofi has been pursuing Genzyme for months, but the biotechnology firm had refused to talk to Sanofi because of its $69 a share offer, which Genzyme said was too low. In August, Sanofi made an unsolicited bid for Genzyme, and went hostile with its offer in October.

Some of Sanofi's biggest products, including the cancer drug Taxotere and the blood-thinner Lovenox, have lost sales to generic rivals, while another big drug, the blood thinner Plavix, is expected to confront generic competition in 2012. Plavix accounted for about 9% of Sanofi's $40 billion sales last year. Sanofi also suffered a research setback last month, when a breast-cancer drug it was testing didn't work as expected in a late-stage study.

Continued in article

From The Wall Street Journal Weekly Accounting Review on November 8, 2013

Fifth Third Moves CFO in SEC Accounting Pact
by: Andrew R. Johnson
Nov 06, 2013
Click here to view the full article on WSJ.com
 

TOPICS: Accounting For Investments, Banking, Fair Value Accounting

SUMMARY: In the third quarter of 2008, says the SEC, Fifth Third Bancorp of Cincinnati, OH, should have classified certain of its loans as held for sale. The loans were reclassified in the fourth quarter. The SEC's filing related to this agreement is available at http://www.sec.gov/Archives/edgar/data/35527/000119312513427656/d622749dex991.htm For quick reference, the bank's 10-Q filing for the quarter ended September 30, 2008 is available at http://www.sec.gov/Archives/edgar/data/35527/000119312508229815/d10q.htm#tx44301_17

CLASSROOM APPLICATION: The article may be used to introduce fair value accounting for investments versus historical cost accounting for loans receivable. Questions also ask students to understand the CFO's personal responsibility for integrity in financial statement filings and systems of internal control.

QUESTIONS: 
1. (Introductory) Of what wrongdoing has the SEC accused Fifth Third Bancorp of Cincinnati?

2. (Advanced) What is the importance of classifying loans as held for sale rather than classifying them as long-term receivables?

3. (Advanced) Chief Financial Officer Daniel Poston certainly wasn't the only one directly responsible for the bank's accounting in the third quarter of 2008. Why then is he the one who is losing his position and facing a one-year ban practicing before the SEC?

4. (Advanced) Do you think that Mr. Poston will return to his position as CFO after his one year ban on practicing in front of the SEC is completed? Explain your answer
 

Reviewed By: Judy Beckman, University of Rhode Island

"Fifth Third Moves CFO in SEC Accounting Pact," by Andrew R. Johnson, The Wall Street Journal, November 6, 2013 ---
http://online.wsj.com/news/articles/SB10001424052702303936904579180252046068872?mod=djem_jiewr_AC_domainid

Fifth Third Bancorp FITB -0.24% has moved its finance chief to a different post in connection with a tentative agreement it reached with the staff of the Securities and Exchange Commission regarding the lender's accounting.

The Cincinnati bank said Daniel Poston will vacate the chief financial officer's and become chief strategy and administrative officer. Fifth Third appointed Tayfun Tuzun, its treasurer, to the role of finance chief.

The SEC is seeking a one-year ban on Mr. Poston's ability to practice before the agency under separate negotiations with the executive, the bank said.

Fifth Third said its agreement in principle stems from an investigation into how Fifth Third accounted for a portion of its commercial-real-estate portfolio in a regulatory filing for the third quarter of 2008. The dispute focuses on whether the bank should have classified certain loans as being "held for sale" in the third quarter of that year rather than in the fourth quarter.

Fifth Third said it will agree to an SEC order finding that the company failed to properly account for a portion of the portfolio but will not admit or deny wrongdoing. The bank will also pay a civil penalty under the agreement, the amount of which wasn't disclosed.

The agreement requires the approval of the SEC commissioners.

A spokeswoman for the SEC and a spokesman for Fifth Third declined to comment.

Mr. Poston, who was serving as Fifth Third's interim finance chief at the time of the activities, is in separate settlement discussions with the SEC under which he would agree to similar charges, a civil penalty and the one-year ban the agency is seeking, the bank said.

Continued in article

Just as early reactions to FAS 142 seemed to have overlooked the complexities in reviewing and testing goodwill for impairment, so too have reactions to complying with the Financial Accounting Standards Board's Statement No. 141 – Business Combinations.

Adopted and issued at the same time as Statement No. 142 in the summer of 2001, the headline news about FAS 141 was the elimination of the Pooling-of-Interest accounting method in mergers and acquisitions. Going forward from June 30, 2001, all acquisitions are to be accounted for using one method only – Purchase Accounting.

This change is significant and one particular aspect of it – the identification and measurement of intangible assets outside of goodwill – seems to be somewhat under-appreciated.

Stephen C. Gerard, Managing Director at Standard & Poor's Corporate Value Consulting, says that there is "general conceptual understanding of Statement 141 by corporate management and finance teams. But the real impact will not be felt until the next deal is done." And that deal in FAS 141 parlance will be a "purchase" since "poolings" are no longer recognized.

Consistent M&A Accounting

The FASB, in issuing Statement No. 141, concluded that "virtually all business combinations are acquisitions and, thus, all business combinations should be accounted for in the same way that other asset acquisitions are accounted for – based on the values exchanged."

In defining how business combinations are to be accounted for, FAS 141 supersedes parts of APB Opinion No. 16. That Opinion allowed companies involved in a merger or acquisition to use either pooling-of-interest or purchase accounting. The choice hinged on whether the deal met 12 specified criteria. If so, pooling-of-interest was required.

Over time, "pooling" became the accounting method of choice, especially in "mega-deal" transactions. That, in the words of the FASB, resulted in "…similar business combinations being accounted for using different methods that produced dramatically different financial statement results."

FAS 141 seeks to level that playing field and improve M&A financial reporting by:

• Better reflecting the investment made in an acquired entity based on the values exchanged.
• Improving the comparability of reported financial information on an apples-to-apples basis.
• Providing more complete financial information about the assets acquired and liabilities assumed in business combinations.
• Requiring disclosure of information on the business strategy and reasons for the acquisition.

When announcing FAS 141, the FASB wrote: "This Statement requires those (intangible assets) be recognized as assets apart from goodwill if they meet one of two criteria – the contractual-legal criterion or the separability criterion."

Unchanged by the new rule are the fundamentals of purchase accounting and the purchase price allocation methodology for measuring goodwill: that is, goodwill represents the amount remaining after allocating the purchase price to the fair market values of the acquired assets, including recognized intangibles, and assumed liabilities at the date of the acquisition.

"What has changed," says Steve Gerard, "is the rigor companies must apply in determining what assets to break out of goodwill and separately recognize and amortize."

Thus, in an unheralded way, FAS 141 introduces a process of identifying and placing value on intangible assets that could prove to be a new experience for many in corporate finance, as well as a costly and time-consuming exercise. Nonetheless, an exercise critical to compliance with the new rule.

Continued at  http://www.cfodirect.com/cfopublic.nsf/vContentPrint/CA13B226B214A04085256CB000512D34?OpenDocument  

From The Wall Street Journal's Accounting Weekly Review on May 7, 2010

SEC Examines Berkshire's Disclosure on Burlington
by: Dennis K. Berman
May 06, 2010
Click here to view the full article on WSJ.com

TOPICS: Disclosure, Disclosure Requirements, Mergers and Acquisitions, SEC, Securities and Exchange Commission

SUMMARY: The article discusses the SEC's investigation into when Berkshire Hathaway disclosed its intentions regarding the railroad Burlington Northern. In question 2, a direct link is provided to the merger press release on Form 8-K made on November 3, 2009.

CLASSROOM APPLICATION: The article is useful for introducing required disclosures, negotiation and potential bidding wars in business combinations. It also highlights the issue of timeliness in defining information usefulness.

QUESTIONS: 
1. (Introductory) According to the article, when did Berkshire Hathaway first announce its intention to buy the railroad company Burlington Northern Sante Fe Corp.?

2. (Advanced) Access the SEC filing on Form 8-K made on November 3, 2009 containing the M&A agreement and joint press release by Burlington Northern Santa Fe Corp. (BNSF) and Berkshire Hathaway, Inc. available at (note that the filing is located with BNSF filings): http://www.sec.gov/Archives/edgar/data/934612/000095015709000805/form8k.htm To whom is this notice given-other shareholders or someone else? Given that both companies made this join press release, at what stage of negotiations was this announcement made?

3. (Introductory) What is the question with the timing of the disclosure made by Berkshire Hathaway?

4. (Advanced) Define the concept of timeliness in the conceptual framework for financial reporting, citing either the source of the definition in U.S. GAAP or IFRS. How does this concept interact with the primary qualities of financial information? In your answer, define these primary qualities as well.

5. (Introductory) Why does early disclosure "help company officers by limiting shareholders' ability to make a surprise takeover offer"?

6. (Introductory) How does early disclosure lead to potential problems in merger and acquisition negotiations? According to the article, how does it work against Warren Buffett's style of acquisition in particular?

Reviewed By: Judy Beckman, University of Rhode Island

"SEC Examines Berkshire's Disclosure on Burlington: Issue Is How Other Railroad Shareholders Were Informed Before Deal in 2009," by Dennis K. Berman, The Wall Street Journal, May 4, 2010 ---
http://online.wsj.com/article/SB10001424052748703322204575226723062858044.html?mod=djem_jiewr_AC_domainid

The Securities and Exchange Commission is examining the disclosures Berkshire Hathaway Inc. made about its $26 billion purchase of Burlington Northern Santa Fe Corp. railroad, said people familiar with the matter.

For a number of weeks, the SEC has been looking at how Berkshire, helmed by billionaire investor Warren Buffett, informed other Burlington shareholders about its offer to buy the company in late October 2009, these people said.

At the time, Berkshire was already a 22.6% holder of Burlington stock. Under a section of securities law generally known as "13D," large holders must promptly alert other stockholders of any "plans or proposals" to control a company. Technically the disclosure, which must be filed with the SEC, should happen within a few business days after an offer, say some securities lawyers. But the matter has long been open to interpretation.

Mr. Buffett declined to comment. The SEC also declined to comment.

Mr. Buffett amended his securities holdings on Nov. 3, 2009, the day the acquisition was announced. Securities filings show that he first indicated he could pay $100 for each Burlington share to company chief executive Matthew K. Rose on the evening of Oct. 23.

The transaction was a highlight of Mr. Buffett's career, and represented his largest-ever deal. Mr. Buffett saw rail transportation as a growing industry over a coming period of higher energy costs. Mr. Buffett declared it an "all-in wager on the economic future of the United States."

The reporting law is intended to help company officers by limiting shareholders' ability to make a surprise takeover offer. But the adherence to and enforcement of this standard has long fallen in a gray area. Potential buyers are loath to disclose a potential deal, fearing that it could upset their ability to complete the transaction. The SEC, meanwhile, has shown only spotty attention to this area of the law over the years, say securities attorneys.

The SEC's corporation-finance division is handling the matter, and is so far just examining the facts of the transaction. The results of that analysis will determine whether SEC's enforcement unit would open an inquiry. Even if the SEC did decide to take action against Berkshire, the penalties would likely be minor, experts say.

Still, the agency has shown a new focus on the law. It recently published some loose guidelines about when potential acquirers are expected to report their interest. At last month's Tulane University Corporate Law Institute, the SEC's mergers and acquisitions chief, Michele Anderson, made remarks about the topic. Acquirers that already hold big stakes are expected to report "not necessarily as late as when they enter a merger agreement," Ms. Anderson said. "The more it becomes probable from the merely possible, there is a need to disclose."

The SEC's move highlights Mr. Buffett's style of deal-making, which has stood apart from other corporate buyers. Eschewing bankers and drawn-out negotiations, Mr. Buffett has instead used a personal appeal, directly building relationships with top company managers and directors, while often signing deals in a matter of days.

This has given him an advantage in buying companies, helping lock out any potential rivals from lobbing in competing bids.

To avoid losing a company to a competitor or driving up the target stock price, deal lawyers say, buyers often interpret the early-reporting requirements broadly, saying that offers aren't "proposals" until they have guaranteed financing, for instance.

"Normally public disclosure of such transactions is made once the parties reach agreement," said Doron Lipschitz, a partner at O'Melveny & Myers LLP, speaking generally about the rule. "The target company and investor usually make their announcement in filing at the same time."

Other lawyers take a harder view, including Stephen Bainbridge, a professor at the UCLA School of Law. "Once the large shareholder decides that it plans to make an offer, that is a material change," said Mr. Bainbridge. "You have a duty to amend your 13D filing promptly. There is no real dispute on this."

One recent legal case touched, at least partially, on the timing of disclosure of merger talks. In a shareholder lawsuit involving the 2004 takeover of Sears Roebuck by Kmart to form Sears Holdings, a U.S. District Court in Chicago found that the companies didn't have to release any information ahead of their transaction, despite shareholder claims that the information should have been disclosed earlier.

A Little Like Dirty Pooling Accounting
Tyco Undervalues Acquired Assets and Overvalues Acquired Liabilities: 
Tyco International Ltd. said Monday it has agreed to pay the Securities and Exchange Commission $50 million to settle charges related to allegations of accounting fraud by the high-tech conglomerate's prior management. The regulatory agency had accused Tyco of inflating operating earnings, undervaluing acquired assets, overvaluing acquired liabilities and using improper accounting rules, company spokeswoman Sheri Woodruff said. 'The accounting practices violated federal securities laws,'' she said.
"Tyco to Pay S.E.C. $50 Million on Accounting Charges," The New York Times, April 17, 2006 --- http://www.nytimes.com/aponline/business/AP-Tyco-SEC-Fine.html?_r=1&oref=slogin

April 17, 2006 reply from Saeed Roohani

Bob,

Assuming improper accounting practices by Tyco negatively impacted investors and creditors in the capital markets, why SEC gets the $50 M? Shouldn't SEC give at least some of it back to the people potentially hurt by such practices? Or damage to investors should only come from auditors' pocket?

Saeed Roohani

April 18, 2006 reply from Bob Jensen

Hi Saeed,

In a case like this it is difficult to identify particular victims and the extent of the damage of this one small set of accounting misdeeds in the complex and interactive multivariate world of information.

The damage is also highly dispersed even if you confine the scope to just existing shareholders in Tyco at the particular time of the financial reports.

One has to look at motives. I'm guessing that one motive was to provide overstated future ROIs from acquisitions in order to justify the huge compensation packages that the CEO (Kozlowski) and the CFO (Schwarz) were requesting from Tyco's Board of Directors for superior acquisition performance. Suppose that they got $125 million extra in compensation. The amount of damage for to each shareholder for each share of stock is rather minor since there were so many shares outstanding.

Also, in spite of the illegal accounting, Kozlowski's acquisitions were and still are darn profitable for Tyco. I have a close friend (and neighbor) in New Hampshire, a former NH State Trooper, who became Koslowski's personal body guard. To this day my friend, Jack, swears that Kozlowski did a great job for Tyco in spite of possibly "stealing" some of Tyco's money. Many shareholders wish Kozlowski was still in command even if he did steal a small portion of the huge amount he made for Tyco. He had a skill at negotiating some great acquisition deals in spite of trying to take a bit more credit for the future ROIs than was justified under purchase accounting instead of virtual pooling accounting.

I actually think Dennis Kozlowski was simply trying to get a bit larger commission (than authorized by the Board) for some of his good acquisition deals.

Would you rather have a smart crook or an unimaginative bean counter managing your company? (Just kidding)

Bob Jensen

Bob Jensen's threads on the Tyco scandals are at http://faculty.trinity.edu/rjensen/Fraud001.htm#PwC

April 18, 2006 message reply Gregg Wilson

Hi Bob Jensen

From Forbes:

<<But Briloff says what's particularly egregious is the fact that Tyco did not file with the SEC disclosure forms (known as 8K filings), which would have carried the exhibits setting forth the balance sheets and income statements of the acquired companies.

"This is an even worse situation than under the old pooling accounting, " Briloff says, "because under that now vestigial method, investors and analysts could dig out the historical balance sheet and income statement for the acquired companies." >>

Ah yes, the good old days, when accountants understood what mattered.

Gregg

April 18, 2006 reply from Bob Jensen

Interesting but still does not mean Abe wanted to pool those statements. Abe fought poolings like a tiger. He never said that accounting information before an acquisition is totally useless. He did say it could be misleading when pooled, especially in relation to terms of the acquisition.

Bob Jensen

Purchase Versus Pooling:  The Never Ending Debate

March 29, 2006 message from Gregg Wilson greggwil@optonline.net

Hope you don't mind another question.

I worked on Wall Street during the other tech mania (late 60's) which included the conglomerate craze. I know pooling-of-interest accounting was kind of tarred and feathered in the ensuing meltdown, but I was never too clear why that was so. I am still wondering why bogus goodwill is preferable to retaining the financial track record of the combined companies. Are you aware of what the actual objections to p-o-i are?

Gregg Wilson

March 29, 2006 reply from Bob Jensen

Some investors are impressed by high ROI or ROE numbers. Keeping the denominator low with old historical cost numbers and the numerator high with future earnings numbers "inflated" ROI and ROE and made the mergers appear more successful than was actually the case.

There are other problems with "dirty pooling."

One of the best-known articles (from Barrons) was written by Professor Abe Briloff about "Dirty Pooling at McDonalds." McDonald's shares plummeted significantly the day that Briloff exposed dirty pooling by McDonald's  --- http://www.jstor.org/view/00014826/ap010167/01a00060/0 

Actually, one of the arguments in favor of purchase accounting rather than pooling of interests is that in an arm's length transaction goodwill can actually be measured, unlike the pie-in-the sky valuations in a hypothetical world.

Bob Jensen

March 29, 2006 message from Gregg Wilson greggwil@optonline.net

Hi Bob Jensen

Well I wasn't able to find a site where I could access Abe's article.

The "old numbers" are worth a lot to this user of financial statements, and I would much rather have the combined track record of the two companies than its obliteration. I am not sure why accountants feel that there is a problem revealing what the past and current combined ROE has been. The pooling-of-interest doesn't create that number, it only preserves it for those who want to use it.

If you mean that the value of the exchanged stock is an actual measurement of goodwill then I would take very serious issue. There is no economic meaning to that number. Companies negotiate an exchange ratio. The relative value of the two stocks may matter, but the value of the exchanged stock has no relevance to the negotiation, so how could it be a measure of anything economic? All you have to do is look at the real cases of stock acquisitions that were made during the market boom to see how true that is and how spurious the numbers became. I always assumed that the amortization rules were changed because of the charade of company after company being forced to report pro forma earnings due to the ludicrous mountains of mythical goodwill.

But even if the goodwill number were determinable why would you want to use it. The point isn't to have accurate values on the balance sheet. The point is retaining the historical relationships of the earnings model. Deferred costs are not assets that you want to value but the merely costs that are going to be expensed and the historical relationship of those costs to the resulting earnings is what tells you what the capital efficiency of the company is. I want that information. Why obliterate it?

Gregg Wilson

March 29, 2006 reply from Bob Jensen

Generally there are market values of the stocks at the date of the acquisition. These give some evidence of value at the time of the merger, although there are blockage factor considerations.

In any case there is a long history of abuses of pooling to mislead investors. In some cases that was the main purpose such that without being able to use pooling accounting, acquisitions did not take place. In other words the main purpose was to deceive.

A summary of FAS 141 is given at http://www.fasb.org/st/summary/stsum141.shtml 

The standard itself discusses a lot of both theory and abuses. In general, academics fought against pooling. About the only parties in favor of pooling were the corporations themselves.

Read the standard itself and you will learn a lot.

Bob Jensen

March 30, 2006 reply from Gregg Wilson greggwil@optonline.net

Hi Bob Jensen

Well I would call that entire FAS 141 a lot of sophistries. Apples and oranges indeed. This is a case of trying to make an apple into an orange and getting a rotten banana.

In the above example, if a company bought another company for more than its net worth, the excess price paid was attributable to goodwill and would have to be written off over a period of years. The problem is that the writing off goodwill creates an expense that lowers earnings. To get around this, companies use an accounting technique called pooling of interest. This practice allows the acquiring company to buy other companies at inflated prices and keep the goodwill charges off the company's books. This strategy has resulted in merger mania. It enables a corporation to buy another company at an inflated price using its own highly priced stock as currency. In honest times, this process would create huge amounts of goodwill that normally would have to be written off against future earnings. Today, companies avoid this detriment to their bottom line by pooling. The Merger Wave

These accounting abuses can be credited to what is behind the current merger wave on Wall Street. Companies are using their inflated stock prices to buy other companies. The result of buying more companies brings in more sales and more profits, which Wall Street loves. Using the pooling method of accounting, companies can acquire other companies at high prices without the consequences of depressing future earnings through the amortization of goodwill.

I was trying to find example of the abuses you were talking about. I thought this was a terrific one. What fantastic misinformation!

The thing that's so laughable about these arguments is that they take investors for fools. In a stock acquisition not a nickel of cash has been expended, so everyone understands that the purchase goodwill is just a little paper farce that the accountants make us go through. The amortization thing doesn't effect the price of the stock because it has no e ffect whatsoever on the company's actual profitability or cash flow. Have you read about the efficient market? I was really struck in this last go around at the willingness of companies to take on billions of dollars in goodwill that literally dwarfed everything else on their balance sheets and caused their GAP earnings to be huge losses. They reported their pro forma earnings and everyone understood that they hadn't really paid 10 billion dollars for a company that was worth 100 million. I looked at a couple of the deals and the share exchange ratios were really very fair relative to the fundamentals (not the share prices). They were good solid deals, between smallish tech companies that were very profitable in the capex bubble and so were richly priced as one would expect. So the accountants caved and changed the rule, and this little pint sized company took some astounding goodwill writeoff the next year and the stock did nothing. Did the guy who wrote 141 really think that phony made up good will is the same thing as actual paid for with cash good will? I always get the feeling that the companies relented on this one so they could fight their battles on the ones that really matter. An orange is an orange, and an apple is an apple.

I think accountants have really misunderstood the whole abuse issue. I worked on Wall Street during the conglomerate fad and spent hours analyzing stock acquisitions. There were some accounting abuses but they were really not about pooling-of-interest. The people that really got hurt were not the investors so much as the entrepreneurs who sold their companies. Textron started the whole conglomerate thing and the business schools wet their pants over the idea and pretty soon you could call yourself a congolmerate and get a high stock price. I can't tell you how tired I got of hearing the word "synergy". What was basically happening was that the companies were making really good deals and getting a lot of value for the stock they were giving up, partly because of the whole aura of the thing. When you get a really good share exchange it makes your earnings higher than they would be otherwise. Of course there is nothing abusive about this. It's just the reality of doing a good deal. The real earnings and cash flow are indeed and in fact actually higher per share for the acquiring company. But of course that meant it took on the qualities of a self-fullfilling prophecy. Investors were not fools then and they're not fools now. They understood perfectly what was going on and hopped on for the ride. It was the entrepreneurs that were selling their companies that were duped. They were the ones that ended up with most of the stock when the bubble burst.

I remember going out to talk to Henry Singleton at Teledyne. What a brilliant man. He was telling me a story about a guy who was peddling his company and wanted a certain price which he was evaluating purely in terms of the value of the stock he was going to receive in the exchange. Henry said that he sent him off to one of the schlock companies that he knew would "pay" him what he wanted. We had our little moment of bemusement, because even though it was early in the melt down stage, the guy was obviously going to come up short. He just wasn't willing to look at what he was getting a whole bunch of shares in, and he wasn't going to be able to sell it for a while. So what do you think? Is it the accountants job to protect that guy from his own greed?

By the way, Henry was playing his own games, and they weren't really about pooling of interest. He was making literally hundreds of stock acquisitions most of which were not really growth companies but good solid little cash cows, and then he would slip in a nice medium sized cash acquisitions once a quarter to make his "internal growth" target. He would say that he was doing 15% external growth (the deal value factor) and 15% internal growth. The thing about pooling was that you could really see what the year-to-year growth of the combined companies was, so Henry had to do his fix. Then after the stock tanked with the other congomerates he was in great shape with all his cash flow so he started doing debt swaps for the depressed stock. I was really sad when I heard he had died prematurely. It would have been fun to see what his next move would have been. The company languished without him.

Anyway I think the whole thing got interpreted as a pooling-of-interest abuse, but as far as I'm concerned it really didn't have anything to do with the accounting treatment. It's not the accountants business to police the markets. In a stock deal the goodwill is all funny money anyways, so the way I see it we are mucking up the balance sheet for no good reason. You can amortize til you're blue in the face but it's not really going to have any affect on anything real. It's not cash and it never was. But you can pretend.

Gregg Wilson

March 30, 2006 reply from Bob Jensen

FASB rules now require writing off goodwill only to the extent it is deemed impaired.

If you want to publish on such issues you have to provide something other than off the top-of-your-head evidence. Do you have any evidence that companies tend to buy other companies at inflated prices above what companies are actually worth in terms of synergy and possibly oligopoly benefits (such as when AT&T bought Bell South). You need to define "inflated prices." About the only good examples I found of this on a large scale was during the S&L bubble of the 1980s and the technology bubble of the 1990s when almost everything was inflated in value. But at the time, who could've predicted if and when the bubble would burst? It's always easier to assess value in hindsight.

In general, it's very hard to define "inflated value" since the worth of Company B to Company A may be far different than the worth of Company B to Company C. You can always make an assumption that CEOs acquiring companies are all stupid and/or crooks, but this assumption is just plain idiotic. Many acquisitions pay off very nicely such as when Tyco bought most of its acquisitions. Even crooks like Dennis Koswalski often make good acquisitions for their companies. Koswalski simply thought he should get a bigger piece of the action from his good deals.

Of course there are obvious isolated cases such as when Time Warner bought AOL, but in this case AOL used fraudulent accounting that was not detected.

I'm a little curious about what you would recommend for a balance sheet of the merged AB Company when Company A buys Company B having the following balance sheets:

Company A
Cash    $200
Land    $100 having a current exit value of $200
Equity ($300)

Company B
Land     $10 having a current exit value of $100
Equity  ($10)

Company A buys all Company B shares for $120 million in cash and merges the accounts. Company A and B business operations are all merged such that maintaining Company B as a subsidiary makes no sense. Employees of Company B are highly skilled real estate investors who now work for Company AB. The extra $20 million paid above the land current values of Company B was paid mainly to acquire the highly skilled employees of Company B.

Company AB
Cash     $ 80
Land          ?
Equity   ($ ?)

Why would a pooling be better than purchase accounting in the above instance? I think not.

Bob Jensen

March 30, 2006 reply from Gregg Wilson greggwil@optonline.net

I certainly didn't mean to imply that cash acquisitions should be treated as pooling-of-interest. On the contrary I was trying to make the point that they are totally different situations, and can't be treated effectively by the same accounting rule. The cash is the whole point.

Gregg Wilson

March 30, 2006 reply from Bob Jensen

I guess I still don't see a convincing argument why pooling is better for non-cash deals since you still have the same problem as with cash deals. That problem is badly out of date historical cost accounts on the books that are totally meaningless in the acquisition negotiations. If they are totally meaningless in negotiations, why should historical costs be pooled into the acquiring firm's book instead of more relevant numbers reflecting the fair values of the tangible assets at the time of the acquisition?

Of course there are many issues that your raise below, but I don't think they argue for pooling.

Bob Jensen

March 30, 2006 reply from Gregg Wilson greggwil@optonline.net

Hi Bob Jensen

Because historical costs are the historical record of the company's capital efficiency. As my old accounting teacher pointed out, the earnings model is a gross approximation at best, but if persued with consistency and conservativeness it can be a good indicator of the capital efficiency of the firm and it's ability to generate a stream of future cash returns. For me the killer argument in that regard is this. The reality of a company is the stream of cash returns itself, dividends if you will, and that's what the stock is worth. It makes no difference whether the company has liberal accounting policies or conservative accounting policies. If applied consistently then that rate of return on equity will define the stream of future cash returns. It can be liberal accounting with a low ROE and high E and a high reinvestment rate, or conservative accounting with a high ROE and low E and a low reinvestment rate, but the resulting stream of dividends is the same. The historical deferred costs and historical ROE are the evidence of value, but they depend on consistent application of some kind of accounting standards and rules whether they be liberal or conservative (conservative has its advantages). I would rather have that evidence than know what the current "fair value" of the assets is. Those values don't help me determine the value of the stock. Pooling of interest is terrific, because it recreates that earnings model history for the combined companies. The historical costs are not meaningless to the negotiations but rather are the basis for the negotiations, for they are the evidence that the companies are using to determine the share exchange ratio that they will accept. A low ROE company will have less to bargain with than a high ROE company, all else being equal. There are potentials for abuse in the differing accounting standards of the two entities, but if major changes in the accounting standards of one of the companies occur, then the accountants should disclose that material fact.

Gregg Wilson

March 30, 2006 reply from Bob Jensen

Hardly a measure of capital efficiency. I have the 1981 U.S. Steel Annual Report back when FAS 33 was still in force. U.S. Steel had to report under both historical cost and current cost bases.

Under historical cost, U.S. Steel reported over $1 billion in net earnings. On a current cost basis, all earnings disappeared and a net loss of over $300 million was reported.

I consider the $1 billion net income reported under historical cost to be a misleading figure of capital efficiency.

I think you should first read the FASB's standard on pooling versus purchase accounting in detail. Then see if you still prefer pooling. Also study http://www.jstor.org/view/00014826/ap010167/01a00060/0 

You might want to compare your analysis below with what Fama states at http://library.dfaus.com/reprints/interview_fama_tanous/ 

Bob Jensen

March 31, 2006 reply from Bob Jensen

Hi Gregg,

The law views this in reverse. Equity is a residual claim on assets under securities laws. But the claim itself has no bearing on the historical (deferred) cost amount since, in liquidation, the historical cost is irrelevant. And in negotiating acquisition deals historical cost is irrelevant. I have trouble imagining acquisitions where it would be relevant since asset appraisals are essential in acquisitions.

Deferred cost such as book value of buildings and equipment is also rendered meaningless by entirely arbitrary accumulated depreciation contra accounts. Your argument does not convince me that pooling is better than purchase accounting in acquisitions.

Since you feel so strongly about this, I suggest that you expose your theories to the academic accounting world. Consider subscribing (free) to the AECM at http://pacioli.loyola.edu/aecm/  (Don't be mislead by the technology description of this listserv. It has become the discussion forum for all matters of accounting theory.)

Then carefully summarize your argument for pooling and see how accounting professors respond to your arguments.

See if you can convince some accounting professors. You've not yet convinced me that pooling is better.

Bob Jensen

April 5, 2006 message from Gregg Wilson greggwil@optonline.net

I have been having an e-mail discussion with Bob Jensen about accounting of stock acquisitions, and he kindly suggested that I post my thoughts on the matter in this forum. I am not an academic and I am here only because, as a user of financial statements, I find purchase accounting of stock acquisitions puzzling.

(1) To me, the value of the exchanged shares is not an economically relevant amount and is certainly not a purchase price. The price of a stock acquisition is the share exchange ratio and what is negotiated is the equity participation of the two groups of stockholders in the combined companies. In the latest boom period purchase accounting often produced extreme purchase prices many times what any cash buyer would have paid and, when amortization was employed, large losses for the acquiror which prompted pro forma reporting. If there was any economic reality to the accounting treatment, why did those managements not lose their jobs? They didn't "pay" the value of the exchanged shares. On the contrary, the share exchange ratio that they negotiated was perfectly reasonable and beneficial.

(2) The exchanged stock value as purchase price is a non-cash paper value which, regardless of the amortization or impairment treatment, is ignored by this investor and, from what I have seen, investors in general. It has no relevance to determining the discounted value of the future cash returns, simply because the acquisition was in fact a combination of equity interests and not a cash purchase and there was never an economically relevant cash cost.

(3) Pooling-of-interest is good because it preserves the historical profitability history of the combined companies and accurately reflects the merger of equity interests which has in fact taken place.

(4) There is nothing deceptive or abusive about pooling accounting. If the ROE is higher it's because that's the right ROE. It will result in a more accurate, and not a less accurate, projection of future cash returns.

If company A and company B are very similar fundamentally and both stocks are selling at 20 and they are negotiating a share for share exchange and interest rates drop suddenly and both stocks go to 25, then A isn't going to think oh-my-gosh we are "paying" 25% more for B and drop out of the negotiations. On the contrary they will take the market action as validation of the negotiated exchange ratio which is the price. The stocks could go to 90 and it still wouldn't change anything except the size of the goodwill on the balance sheet of the combined companies that I have to back out of my analysis.

Gregg Wilson

April 5, 2006 reply from  [Richard.C.Sansing@DARTMOUTH.EDU]

--- Gregg Wilson wrote: I have been having an e-mail discussion with Bob Jensen about accounting of stock acquisitions, and he kindly suggested that I post my thoughts on the matter in this forum.

(snip) --- end of quote ---

Consider the following two sets of transactions:

1. P Corporation (P is for purchaser) raises $100 by issuing ten new shares to the capital market. It uses the $100 cash to purchase 100% of the outstanding stock of T (as in Target) Corporation.

2. P issues ten new shares to the stockholders of T in exchange for 100% of the outstanding stock of T.

Questions:

1. Should the accounting for the assets of T in the consolidated financial statements of P differ between these two transactions?

2. The crux of your critique of purchase accounting seems to your assertion: "To me, the value of the exchanged shares is not an economically relevant amount and is certainly not a purchase price."

a. Is the $100 cash raised by P in transaction #1 above an economically relevant amount?

b. Is the $100 cash transferred by P to the shareholders of T in transaction #1 above a purchase price?

Richard C. Sansing
Associate Professor of Business Administration
Tuck School of Business at Dartmouth
100 Tuck Hall Hanover, NH 03755

April 5, 2006 reply from Gregg Wilson greggwil@optonline.net

Hi Richard Sansing

I would say the two transactions are not equivalent.

In 1. the stockholders of T end out with $100. In 2. the stockholders of T end out with shares of stock in P.

1. is still a cash purchase and
2. is still an exchange of shares.

Say that P has 100 shares outstanding. In 2. what P and T have negotiated is that in combining the two companies the shareholders of T will end up with 10 shares in the combined companies and P will end up with 100. That is obviously based on an assessment that the value of P is 10 times the value of T based on their relative fundamentals and ability to produce future cash returns. The price at which P can sell it's stock to some third party is not relevant.

Gregg Wilson

April 6, 2006 reply from  [Richard.C.Sansing@DARTMOUTH.EDU]

--- Gregg Wilson wrote:

I would say the two transactions are not equivalent.

In 1. the stockholders of T end out with $100. In 2. the stockholders of T end out with shares of stock in P.

1. is still a cash purchase and 2. is still an exchange of shares.

--- end of quote ---

That the former shareholders of T wind up with different assets in the two settings is not in dispute. Let's try this once more.

In response to your original post, I posed three questions. They were:

1. Should the accounting for the assets of T in the consolidated financial statements of P differ between these two transactions?

2. a. Is the $100 cash raised by P in transaction #1 above an economically relevant amount?

b. Is the $100 cash transferred by P to the shareholders of T in transaction #1 above a purchase price?

You answered none of them. You did remark:

"The price at which P can sell it's stock to some third party is not relevant."

but I did not pose a question to which that is a plausible answer. I have stipulated a transaction, that P sells--not could sell, did sell--ten new shares of P stock in exchange for $100 cash as part of transaction #1. Question 2a is a simple one. Is the $100 cash that P received for its stock in the stipulated transaction an economically relevant amount? If later in the discussion you want to dispute a premise in an argument I advance, you are of course free to do so. But I have not yet advanced an argument. I have simply posed some questions.

You have chosen to enter a community in which abstract reasoning involving hypothetical examples the norm. You can participate in this community, or not. If you answer the three questions, we can proceed, because then I think I can understand what it is about the purchase method of accounting that you find objectionable. But right now I am unsure how you are thinking about the problem.

Richard C. Sansing
Associate Professor of Business Administration
Tuck School of Business at Dartmouth
100 Tuck Hall Hanover, NH 03755

April 6, 2006 reply from Gregg Wilson greggwil@optonline.net

Hi Richard Sansing

Maybe I should qualify my "Yes" answer. Answers 2 and 3 are yes to the extent they are economically relevant within transaction set 1. They are not economically relevant to transaction set 2.

Gregg Wilson

April 6, 2006 reply from  [Richard.C.Sansing@DARTMOUTH.EDU]

---Gregg Wilson wrote:

Answer to all questions is yes.

Maybe I should qualify that. Answers 2 and 3 are yes to the extent they are economically relevant within transaction set 1. They are not economically relevant to transaction set 2.

--- end of quote ---

Okay, that helps. Given your answers, I think I can put forward the case for purchase accounting. Transaction set #1 is recorded in the following manner.

Sale of new equity for cash:

Cash 100
     Stockholder equity 100

Purchase of T's assets for cash:

Assets 100
     Cash 100

When the smoke clears, P has recorded assets with a book value of 100 and stockholder equity of 100.

Purchase accounting takes the view that P's acquisition of T's assets for stock essentially collapses these two transactions into one, recording the value of the T assets at the market price of the P stock. In contrast, if T's assets had a book value of 60, pooling of interest would record assets of 60 and equity of 60.

The issue is whether this "collapsing" is appropriate. P and T certainly wind up in the same position under both transactions. Whether the shareholders of P and T are in the same position depends on their portfolio choices.

Suppose first that I behave in accordance with the principles of Capital Markets 101, in which I hold the market portfolio plus the risk-free asset. Before either transaction #1 or #2, I hold (say) 10 P shares (out of 100 outstanding) and 1 T share (out of 10 outstanding).

After either transaction, I own 11 P shares (out of 110

outstanding.) If all shareholders behave as I do, then every party associated with the transaction is in the same position under both sets of transactions. The burden seems to be on those advocating the pooling method to explain why the accounting should differ when the results to every party are the same.

Now suppose instead that shareholders, for whatever reason, do not behave in this manner, and the two transactions lead to substantive differences at the shareholder level (but not at the corporate level). Should differences between the two transactions at the shareholder level dictate different accounting treatments at the corporate level? Why?

Finally, let's consider the assertions you made in your original post.

"To me, the value of the exchanged shares is not an economically relevant amount and is certainly not a purchase price. (snip) In the latest boom period purchase accounting often produced extreme purchase prices many times what any cash buyer would have paid..."

When the stock was issued for cash, you considered the cash price paid economically relevant (my question 2a); and when the assets were sold for cash, you considered it a purchase price (my question

2b.) Yet when the transaction is collapsed, you consider the market value of shares an not economically relevant amount and not a purchase price. So if transaction were arranged as a stock deal, are you arguing that P would issue more than ten shares to the shareholders of T in exchange for their T stock? Why?

Richard Sansing

April 7, 2006 reply from Gregg Wilson greggwil@optonline.net

Hi Richard Sansing

I was going to followup this morning, and noticed that you had already responded.

On the details of your case... What I didn't understand was the equivalence of the subscribers to the P stock, and the T shareholders. Why would we presume that they are one in the same? The hypothetical subscribers to the P stock obviously would view the price of P as economically relevant. But the T shareholders are only interested in the shares of P that they end up with. From their point of view the collapsible transaction could be executed at any price and it would still bear the same result for them. It's a wash with regard to price. That is why I qualified my response to question 2 by indicating that it was not economically relevant to transaction 2. The price of P is an economic reality, but not one which consititutes a purchase price of T.

I wouldn't say that pooling looks to the book value as a value of the combined companies, any more than book value is the value of any other company. What pooling does is reflect the merging of the two historical earnings and financial records of the two companies to reflect that the nature of the transaction as a merging of equity interests with an indeterminate "purchase price".

I had never thought about the compensation issue. I'll get back to you if I can figure something out.

Gregg

April 7, 2006 reply from  [Richard.C.Sansing@DARTMOUTH.EDU]

---Gregg Wilson wrote:
P and T have negotiated that P should issue ten shares in exchange for T stock. That is the economic reality. (snip) And there is no economic reason that we should pick the one that happens to coincide with the actual current price of P's stock, because that was not an input of determining the exchange ratio. The problem is that there is no determinant value for a share exchange acquisition. Using the current P stock price is merely an arbitrary convention (snip)
--- end of quote ---

The current market price of P is part of the economic reality, as is the current book value of T. Purchase accounting looks to the former to record the assets of T on the books of P; pooling looks to the latter.

Okay, time for a new thought experiment. The CEO of P corporation receives a salary of $400K plus 1,000 shares of P stock on July 1. These are shares, not options, and they are not restricted. On July 1, when the shares were delivered to the CEO, the stock had a market value of $60 per share, a book value of $40 per share, and a par value of $1 per share. Note that the amount of shares delivered is not a function of the stock price.

Record the entry for compensation expense for the year. The accounts are provided below.

Compensation expense
     Cash Stockholder's equity

Richard C. Sansing
Associate Professor of Business Administration
Tuck School of Business at Dartmouth
100 Tuck Hall Hanover, NH 03755

April 6, 2006 reply from Gregg Wilson greggwil@optonline.net

Hi Richard Sansing

I was going to follow up this morning, and noticed that you had already responded.

On the details of your case... What I didn't understand was the equivalence of the subscribers to the P stock, and the T shareholders. Why would we presume that they are one in the same? The hypothetical subscribers to the P stock obviously would view the price of P as economically relevant. But the T shareholders are only interested in the shares of P that they end up with. From their point of view the collapsible transaction could be executed at any price and it would still bear the same result for them. It's a wash with regard to price. That is why I qualified my response to question 2 by indicating that it was not economically relevant to transaction 2. The price of P is an economic reality, but not one which consititutes a purchase price of T.

I wouldn't say that pooling looks to the book value as a value of the combined companies, any more than book value is the value of any other company. What pooling does is reflect the merging of the two historical earnings and financial records of the two companies to reflect that the nature of the transaction as a merging of equity interests with an indeterminate "purchase price".

I had never thought about the compensation issue. I'll get back to you if I can figure something out.

Gregg

April 7, 2006 reply from  [Richard.C.Sansing@DARTMOUTH.EDU]

--- Gregg Wilson wrote:

On the details of your case... What I didn't understand was the equivalence of the subscribers to the P stock, and the T shareholders. Why would we presume that they are one in the same? The hypothetical subscribers to the P stock obviously would view the price of P as economically relevant. But the T shareholders are only interested in the shares of P that they end up with. From their point of view the collapsible transaction could be executed at any price and it would still bear the same result for them. (snip)

I had never thought about the compensation issue. I'll get back to you if I can figure something out.

--- end of quote ---

The setting in which P and T shareholders are the same is an interesting special case in which the distinction you regard as crucial--the difference in what the T shareholders hold after transaction #1 and transaction #2--vanishes. And it is not a unreasonable case to consider, as it is consistent with finance portfolio theory in which all investors hold the market portfolio.

Let me restate what I hear you saying to see if I understand. Investors that receive P stock for cash care about the price of P stock. Investors that receive P stock in a merger care only about the number of shares they receive, but do not care about the price of those shares. Do I have that right?

Your answer to the compensation question will, I think, help me understand how you are framing these issues.

Richard Sansing

April 7, 2006 reply from Gregg Wilson greggwil@optonline.net

Hi Richard Sansing

I am afraid I am not well-versed in the compensation/option issues though I probably should do better. So without the benefit of prior knowledge...

I guess if there is a compensation expense, it is not necessarily one that is determinable. If there were 100,000 shares outstanding, then from the owners point of view they expect that the incremental net cash returns produced by the extra efforts of the CEO motivated by the stock grant can be valued at a minimum of 1/100 of the value of the company's future cash returns without the CEO's extra effort. But relative values aren't costs and it's unclear to me whether the owners care what the current price of the stock is. Maybe not since the grant is not a function of the stock price. That's as far as I've gotten. I need to get some other things done. I'll keep thinking on it, but I seem to be stumped for now.

Gregg Wilson

April 7, 2006 reply from  [Richard.C.Sansing@DARTMOUTH.EDU]

Hi Gregg Wilson,

I think I am starting to understand your perspective, but I need a little more input from you. First, here are some excerpts from your recent contributions to this thread.

---Gregg Wilson wrote: I guess if there is a compensation expense, it is not necessarily one that is determinable. (Note: The compensation consisted of $400K cash and 1,000 shares of stock with a market price of $60 per share--RS)

...it's unclear to me whether the owners care what the current price of the stock is.

And there is no economic reason that we should pick the one that happens to coincide with the actual current price of P's stock.

Using the current P stock price is merely an arbitrary convention.

The price at which P can sell it's stock to some third party is not relevant.

The price of P is relevant not as an absolute number, but only in terms of its ratio to the real or imputed price of T.

---end of quotations

In the compensation issue that I posed, I stipulated that the market value of the stock was $60 per share. Tell me what that number means to you. At the most fundamental level, why do you think the price might be $60 instead of $6 or $600? I'm not looking for a "because that's where the market cleared that day" answer, but something that gets at the most primitive, fundamental reasons stock prices are what they are. And when they change, why do they change?

Richard Sansing

April 8, 2006 reply from Gregg Wilson greggwil@optonline.net

Hi Richard Sansing

That's easy. I subcribe to the dividend-discount-model view of stock prices. Stock prices are basically a function of interest rates and expected sustainable future profitability (ROE; the best estimator we have (with reinvestment rate) for those future cash returns).

In fact I use my own DDM to convert stock prices to expectational ROEs. Such a DDM is a complete model of stock valuation, and can fully explain stock price levels from the 10-12% ROE low reinvestment low interest rate period of the late 30s, to the 12-15% ROE high interest rate period of the 70s, to the 25% cap-weighted ROE and low interest rates of the capex peak in 2000. Stock prices are extremely volatile because they are a point-in-time market consensus of the future sustainable profitability of the company. A decline in profitabliity expectations will typically produce a price change of two or three times the magnitude, while a change in discount rate will have a more subdued impact.

Gregg Wilson

April 8, 2006 reply from  [Richard.C.Sansing@DARTMOUTH.EDU]

--- Gregg Wilson wrote: I subscribe to the dividend-discount-model view of stock prices. (snip) --- end of quote ---

Understood. The theme that has emerged in this thread is that you are uncomfortable in situations in which GAAP would use the current market price of the firm's stock as an input when determining an accounting entry.

Let's put aside the purchase/pooling dispute to look at the compensation question. Under the set of facts that I stipulated, I don't think there is any controversy regarding the appropriate accounting treatment. It would be:

Compensation expense $460K Cash $400K Equity $60K

A rationale for this treatment is to decompose the equity transfer into two components. First, suppose the firm sells 1,000 shares of new equity to the CEO at the market price of $60 per share (debit cash, credit equity); second, suppose the firm pays the CEO a cash salary of $460K (credit cash, debit compensation expense.) Collapsing these two transactions into one (transfer of $400K cash plus equity worth $60K in exchange for services) doesn't change the accounting treatment.

Now change some of the numbers and labels around and let the firm issue new P equity to T in exchange for all of its equity. The purchase method uses the value of the P stock issued to record the assets and liabilities of T.

Which brings us full circle to your original post. You wrote:

"To me, the value of the exchanged shares is not an economically relevant amount and is certainly not a purchase price."

I argue that the value of P stock is relevant and is a purchase price, in both the compensation case and P's acquisition of T.

Richard Sansing

April 9, 2006 reply from Gregg Wilson greggwil@optonline.net

Hi Richard Sansing

I trust you are having a pleasant weekend. Before tackling the compensation case etc, can you tell me how we account for open market share repurchases.

Gregg Wilson

April 10, 2006 reply from  [Richard.C.Sansing@DARTMOUTH.EDU]

--- You wrote: Before tackling the compensation case etc, can you tell me how we account for open market share repurchases. --- end of quote ---

Credit cash, debit equity; details can vary depending on whether the repurchase is a major retirement or acquiring the shares to distribute as part of compensation. If the latter, the debit is to Treasury Stock.

Richard Sansing

April 11, 2006 reply from Gregg Wilson greggwil@optonline.net

Hi Richard Sansing

Well I'm still in the same place. It seems to me that when a company pays an employee $60,000 in cash they are compensating them for services rendered in that value. When a company grants stock to an employee they are diluting the interests of the current equity participants in the expectation that the employee will be motivated to more than compensate them by an improved stream of cash returns in the future; the point of making the employee an equity participant in the first place, rather than an immediately richer individual. So I don't see the relevance of the price of the shares to the trans 2 again. Except in this case the use of the market share price seems even more suspect in the collapsible transaction, since the company and the CEO could execute the wash transactions between themselves at any price. Also the dilution is the cost, so adding an additional phantom non-cash cost seems to me to be a double counting. It also has the same characteristics as the pooling transaction where very bizarre results could be possible. If a company had a 50 PE then a 2% dilution would erase the company's entire earnings for the period while if the company had a 10 PE a 2% dilution would erase 20% of the earnings. It's the same 2% dilution.

So is that it Richard? Am I a hopeless dolt? I'm sorry but I can't get there on the collapsible transaction. Nor do I understand why the lack of rational result doesn't matter to anyone. I don't want to go look up the data again, but I know when JDS Uniphase bought E-tek the share exchange was quite reasonable but the value of the exchanged stock was in the multi billions and was probably like 500 times the eanrings of E-tek. So when this pipsqueek company goes to raise billions of dollars at their current market price, it's not just whether they could sell that much stock, but rather how they would justify it to the buyers. "Use of Proceeds: we are going to go out and make a cash acquisition of a company called E-tek and we are going to pay billions of dollars and 500 times E-teks's earnings and many many multiples of book value and sales." So what would their real chances be of getting away with that, and why doesn't that seem like a phoney number to anyone? Why doesn't it seem funny that the "prices" of stock purchase acquisitions are basically randomly distributed from the reasonable to the ludicrous to the sublime? Isn't that evidence that the price is uneconomic? Is this really the basic justification for the economic relevance of the purchase number, or is there something more?

Gregg Wilson

April 11, 2006 reply from  [Richard.C.Sansing@DARTMOUTH.EDU]

--- Gregg Wilson wrote:

It seems to me that when a company pays an employee $60,000 in cash they are compensating them for services rendered in that value. When a company grants stock to an employee they are diluting the interests of the current equity participants in the expectation that the employee will be motivated to more than compensate them by an improved stream of cash returns in the future; the point of making the employee an equity participant in the first place, rather than an immediately richer individual. (snip) Why doesn't it seem funny that the "prices" of stock purchase acquisitions are basically randomly distributed from the reasonable to the ludicrous to the sublime? Isn't that evidence that the price is uneconomic?

--- end of quote ---

I did not stipulate an assumption that the employee had to hold the 1,000 shares granted.

The interests of the current stockholders are not diluted in the specified transaction ($400K cash plus stock worth $60K) relative to an alternative cash compensation arrangement of equal value ($460K cash.)

You had earlier indicated a belief that stock prices are best explain by a dividend discount model. Now you suggest that they are random. If you think they are random, of course, I quite understand your discomfort using stock price as an input to the accounting system; but GAAP can use stock price as an input in many transactions, and it is that, not the purchase method per se, that appears to trouble you.

Anecdotes regarding one firm "over-paying" for another in a stock deal don't add much to our understanding, and in any case the issues involving merger premiums and acquisition method may be unrelated to the financial accounting treatment of the acquisition. There is a large and growing literature on this topic; see for example:

Shleifer, A., and R. Vishny. 2003. Stock market driven acquisitions. Journal of Financial Economics 70 (December): 295-311.

Richard Sansing

April 11, 2006 reply from  [Richard.C.Sansing@DARTMOUTH.EDU]

--- Gregg Wilson wrote:

<<> The interests of the current stockholders are not diluted in the specified > transaction ($400K cash plus stock worth $60K) relative to an > alternative cash compensation arrangement of equal value ($460K > cash.)>>

I'm confused. Aren't there 1,000 more shares outstanding?

--- end of quote ---

Yes. Suppose before any compensation is paid, 100K shares are outstanding and the firm is worth $6,460,000. After we pay $460K compensation, the firm is worth $6,000,000, or $60 per share.

If instead we compensate the CEO with $400K and 1,000 shares, after compensating the CEO the firm is worth $6,460,000 - $400,000 =$6,060,000 and 101K shares are outstanding, still with a value of $60 per share (because $6,060,000/101,000 = $60).

With regard to the rest of the thread, I think we are going around in circles. Purchase accounting uses the price of P shares to record the assets of T on P's financial statements. If that price is meaningful, goodwill is meaningful; if the price is random, goodwill is too.

Richard Sansing

April 11, 2006 reply from Gregg Wilson greggwil@optonline.net

Hi Richard Sansing

If I spend $460,000 I certainly hope that my company isn't worth $460,000 less or I certainly wouldn't spend the money. Hopefully the present value of the impact of the $460,000 on future net cash returns will at least exceed the cash expenditure. The same could be said for the 1,000 shares, although they are not a book cost but merely a redistribution of equity participation.

But by your logic I should point out that the company was worth $60.60 per share after the $400,000 total loss expenditure. Now by issuing 1,000 shares the company is only worth $60.00 per share. Dilution?

Well it has certainly been an interesting conversation, and I do thank you for your time and interest. I have learned a great deal. I would agree that we are at an impasse. All my best to you and yours.

Gregg Wilson

April 11, 2006 reply from Gregg Wilson greggwil@optonline.net

Hi Richard Sansing

Sorry for the confusion. I was referring to the value of the exchanged shares of stock in the purchase acquisitions, the "price" that purchase accounting puts on the deal which becomes in fact random because it bears no relationship to the economic basis of the negotiation.

<<> The interests of the current stockholders are not diluted in the specified > transaction ($400K cash plus stock worth $60K) relative to an > alternative cash compensation arrangement of equal value ($460K > cash.)>>

I'm confused. Aren't there 1,000 more shares outstanding?

> Anecdotes regarding one firm "over-paying" for another in a stock > deal don't add much to our understanding,>>

Apparently not, but it should. We should be asking why any of those managements still have a job. The point is they didn't overpay. The share exchange ratio in the JDS/E-tek deal was quite reasonable and resulting in a fair allocation of equity ownership between the two groups of shareholders. It just had nothing to do with the market value of the JDS stock that was exchanged. The monstrocity of the goodwill is a tip off that something is wrong about the treatment, not that the buyer overpaid.

<<> merger premiums and acquisition method may be unrelated to the financial > accounting treatment of the acquisition.>>

I think that's right. Management has caught on that the market doesn't care about the phony goodwill and they just do what's right for the company. There's always pro forma reporting if the GAAP reporting gets too messed up.

Gregg Wilson

April 12, 2006 reply from Bob Jensen

Hi Gregg,

You wrote: "There's always pro forma reporting if the GAAP reporting gets too messed up." End Quote

I hardly think pro forma does a whole lot for investors when "GAAP gets messed up." The problem is that you can't compare pro forma, anything-goes, reports with any benchmarks at all --- http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#ProForma

Appealing to pro forma reporting only weakens your case for an already defenseless case for pooling.

Bob Jensen

April 11, 2006 reply from Gregg Wilson greggwil@optonline.net

Hi Bob Jensen

I think you misunderstand my point. I am surely not defending pro forma reporting. I would assume that one reason goodwill amortization was suspended was that it left companies with no other option. Management rightly assumes that investors want to know what the company is actually earning. If goodwill amortization was suspended for some other reason, what might it have been?

Gregg Wilson

April 13, 2006 reply from Gregg Wilson greggwil@optonline.net

Hi Richard Sansing and anyone who would care to reply.

We have come to an impasse on purchase accounting, but I did have a question on pooling that I wanted to ask you about.

I am old enough to have been hanging around Wall Street research departments in my misspent youth, and was there for the conglomerate craze in the late sixties, and these are the things I remember. After the Harvard B School did there endorsement of Textron, all you had to do was call yourself a conglomerate and talk about synergy and you'd have an immediate following for your stock. Not only that, but you seemed to be able to make share exchange acquisitions on favorable terms which were accretive to your earnings, and pretty soon you had a kind of self-fullfilling prophecy going on. I did some work on Teledyne and even went out to California and met Henry Singleton. He used to talk about 15% internal growth, and 15% external growth. The external part was the accretion to earnings from stock acquisitions. Well we know that the whole thing ended badly, although Henry was nobody's fool and had been buying little cash-cow companies all along despite the sales pitch, so he was in far better shape than some.

Now for years afterwards you keep hearing this idea that pooling is abusive because companies can use their "high priced" stock to make acquisitions, especially in periods of market enthusiasm like the late sixties. I guess what is really being said is that companies stand a better chance of making accretive acquisitions when times are good and the stock is selling at a high price, and the whole thing is in danger of becoming another ponzi scheme like the conglomerate fad all over again, because the accretion to earnings will then reinforce the high price of the stock. There is a perception that the price of the stock matters and because it matters we have to somehow account for that mattering in the accounting treatment of the acquisition.

My biggest concern with this conclusion is that the problem is not the accounting treatment. If a company makes a favorable share exchange acquisition which is accretive to earnings, then that is what has happened. That is an accurate portrayal of economic reality. There is no denying that the company made a GOOD DEAL. They ended up with a share of the combined companies that is quite favorable to their interests. The second problem is that in many circumstances the value of the exchanged shares is much less of a factor than we fear. If the acquired company has publically traded shares, then the price of those shares will be reflecting the current market expectations as well. There is little motivation on the part of the seller to consider the deal in terms of the putative purchase value of the exchanged shares, because they can already cash in at a "high price". It is the relative values of the two share prices that will be the consideration. JDS Uniphase negotiates a share exchange acquisition with E-tek. The share exchange ratio is pretty fair to both companies, and is not really particularly accretive or advantageous to JDS, despite the fact that the value of the exchanged shares is in the multi billions of dollars and many many times what any reasonable cash buyer would pay. E-tek has a "high price" stock already. They don't need JDS to cash in on the market's current enthusiasm for net stocks. Would there be anything abusive or deceptive about accounting for this deal as a pooling-of-interest?

Now I won't deny the fact that the price of the acquirors stock can influence the deal. Henry himself told me a story about a seller that came to him and was looking for a certain "price" expressed in terms of the value of the exchanged shares that he expected to get. The seller was a private company owned by a single entrepreneur, not untypical of the sellers at that time. Henry couldn't give him that many shares for his company because it wouldn't have met his accretion requirments, but he sent him to another conglomerator who he knew would, because that company's stock was flying high relative to it's underlying profitability which didn't compare to Teledyne's. The seller got his deal, but by the time the sellers shares came out of lockup that company was almost bankrupt. Though we think of the crash in conglomerate stocks in terms of the poor investors, it was really the sellers who were the biggest victims of the conglomerate fad, because they were left holding a much bigger proportion of the bag. And the investors weren't really investors. They were speculators and knew perfetly well they were playing a musical chairs game. There are two points (1) the sellers may consider the deal in terms of the value of the exchanged shares, particularly if they are non-publically-traded sellers, but they would probably be well advised to also consider that the shares they receive represent an equity interest in the combined companies, and (2) whatever the seller's motivation, the buyer will always be looking at the deal in terms of their equity share of the combined companies and whether the deal will be accretive or dilutive to their interests.

When we say that pooling is abusive and deceptive what are we really talking about? Is it pooling itself, or is it the fear that rollup companies can make those self-fullfilling accretive acquisitions because of the desire of sellers to cash in on the market value of that stock, and that is somehow an evil thing? Is it really our responsibility as accountants to police the market and try to keep that from happening? Is an accretive acquistion really deceptive? Didn't the company actually make a good deal? Whom are we really protecting from whom?

Gregg Wilson

April 13, 2006 reply from  [Richard.C.Sansing@DARTMOUTH.EDU] -- end of quote ---

--- Gregg Wilson wrote:

Hi Richard Sansing and anyone who would care to reply.

When we say that pooling is abusive and deceptive what are we really talking about?

--- end of quote ---

I will pass on continuing this thread, except to reiterate that your unhappiness with GAAP extends well beyond the purchase method. If we can't agree that the transfer of $60K of a publicly traded company's own stock, unrestricted, to an employee in exchanges for services should be accounted for as an expense of $60K, I doubt we can come to agreement on accounting for more complicated transactions that involve the transfer of a company's stock for anything other than cash.

Richard Sansing

April 13, 2006 reply from Gregg Wilson greggwil@optonline.net

Hi Richard Sansing

Interesting argument. Sort of a combination of all or none and falling back on good authority. Well you did better than Bob Jensen's suggested reading approach, and for that I am grateful. My wife once opined that we should be happy to have heretics for they help us test the veracity of our faith. Still I better leave before I get burned at the stake.

Regards,
Gregg Wilson

April 14, 2006 message from Gregg Wilson greggwil@optonline.net

GAAP espouses the economic entity assumption. In what way does transferring stock to an employee represent a cost to the company? Is there any tangible evidence that the company is worse off? Does it have less cash, dimmer prospects, damaged intangible assets? It is a cost to the shareholders. According to GAAP they are distinct from the company.

Regards,
Gregg Wilson

April 15, 2006 reply from Bob Jensen

Hi Gregg,

Following your logic to its conclusion, firms need not pay employees in anything other than paper. Why bother giving them assets? Just print stock certificates and have them toil for 60 years for 100 shares of stock per week.

This is tantamount to what the Germans did after World War I. Rather than have the banks create marks, the German government just printed millions of marks that soon became worth less than the paper they were printed on. It eventually took a wheel barrow full of marks to buy a slice of bread (literally).

Suppose a firm pays $120 in cash to an employee and the employee pays $20 in income taxes and invests $40 in the open market for 40 shares of his employer's common shares. What is different about this if the company pays him $80 in cash and issues him 40 shares of treasury stock? The employee ends up in the same situation under either alternative. And he or she owes $20 in taxes in either case. Stock must often be issued from the treasury of shares purchased by the company on the open market since new shares have pre-emptive rights that make it difficult to pay employees in new shares.

If employees instead are given stock options or restricted stock, the situation is more complicated but the principle is the same. The stock or the options must be valued and taxes must eventually be paid on the value received for his or her services.

As far as what is wrong with pooling, I told you before your exchanges with Professor Sansing that the main problem with pooling is the reason firms want pooling. They like to keep acquired net assets on the books at very old and outdated historical costs so that future revenues divided by outdated book values show high rates of return (ROIs) and make managers who acquired the old assets look brilliant.

Other abuses are described in the paper by Abe Briloff on "Dirty Pooling" that I sent to you --- Briloff, AJ 1967. Dirty pooling. The Accounting Review (July): 489-496 --- http://www.jstor.org/view/00014826/ap010167/01a00060/0 

I hope you will read Abe's paper carefully before continuing this thread.

Bob Jensen

April 15, 2006 reply from  [Richard.C.Sansing@DARTMOUTH.EDU] -- end of quote ---

These issues are covered Statement of Financial Accounting Standards No. 123, which you can find on the FASB website, http://www.fasb.org .

The excerpt that follows states the general rule.

This Statement requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award.

Richard Sansing

April 15, 2006 message from Gregg Wilson greggwil@optonline.net

Hi Bob Jensen,
Hope all is well with you.

I am not arguing from the employee's point of view. What I am arguing is that the company can pay the employee cash, but if the employee is being paid stock it is not the company but the shareholders who are doing the paying, so it cannot be a cost to the company. The employee is being paid something that belongs to the shareholders, and does not belong to the company. The ownership interest is distinct from the company according to the economic entity assumption.

<<As far as what is wrong with pooling, I told you before your exchanges with Professor Sansing that the main problem with pooling is the reason firms want pooling. They like to keep acquired net assets on the books at very old and outdated historical costs so that future revenues divided by outdated book values show high rates of return (ROIs) and make managers who acquired the old assets look brilliant.>>

I would argue that the costs of the acquired firm are no more old and outdated than any other company that follows GAAP accounting procedures. There is no such thing as an "outdated" book value. The earnings model matches costs and revenues consistently and conservatively over time and that is what makes the return on equity number meaningful. Adjusting those costs to some other random value at a random point in time makes the return on equity number NOT meaningful. The return on equity of the combined companies under pooling is not an inflated return on equity that is meant to make the management look brilliant. It is merely the correct return on equity, and the correct measure of the capital efficiency of the combined companies. It is the return on equity that should be used to project future cash returns in order to determine the value of the company as an ongoing enterprise.

Suppose there are two companies that are both highly profitable and both have 30% ROEs. Is there something misleading about a pooling acquisition where the combined ROE of the two companies is pro forma'ed at a 30% ROE? Is it more meaningul to write up the assets of the acquired company by some phoney goodwill amount so that the combined number will now be 15% ROE? Which number is going to produce a more accurate assessment of the value of the combined companies going forward? For a cash acquisition there has been an additional economic cash cost and the ROE is rightfully lower. But there is no such cost, cash or otherwise, when the equity interests are combined through a share exchange.

Gregg Wilson

April 15, 2006 reply from Bob Jensen

Sorry Greg,

You show no evidence of countering Abe Briloff’s real contention that pooling is likely to be “dirty.” It has little to do with stock valuation since the same “cost” has been incurred for an acquisition irrespective of whether the bean counters book it as a purchase or a pooling. The pooling alternative has everything to do with manipulation of accounting numbers to make managers look like they increased the ROI because of their clever acquisition even if the acquisition is a bad deal in terms of underlying economics.
Briloff, AJ 1967. Dirty pooling. The Accounting Review (July): 489-496 --- http://www.jstor.org/view/00014826/ap010167/01a00060/0 

I doubt that you’ve convinced a single professor around the world that pooling provides better information to investors. Pooling was banned years ago because of widespread opinion that pooling has a greater potential of misleading investors than purchase accounting. If the historical cost net book value of the acquired firm is only half of the current value relevant to the acquisition price, there is no way that future ROIs under pooling and purchasing can be the same. You’ve set up a straw man.

Please don’t bring stock dividends into this debate. Stock dividends and stock splits only confuse the issue. Stock dividends must be distributed to all shareholders and are merely a means, like stock splits, of lowering share prices without changing the value of any shareholder’s investment. Certainly stock dividends cannot be issued selectively to employees and not outside investors. The main argument for large stock dividends/splits is to lower share prices to attract smaller investors into buying blocks of shares without having to pay odd-lot commissions in the market. The only argument for small stock dividends is to mislead shareholders into thinking they are getting something when they are not getting anything at all. Studies show the market is very efficient in adjusting prices to stock dividends and splits.

Certainly not a single professor around the world has come to your defense. It’s time to come up with a new argument Gregg. You must counter Abe’s arguments to convince us otherwise. The only valid argument for pooling is that markets are perfectly efficient irrespective of bean counter reporting. That argument holds some water but it is a leaky bucket according to many studies in recent years. If that argument was really true, management and shareholders would not care what bean counters do. Managers are in reality very concerned about bean counting rules. Corporations actually fought tooth and nail for pooling, but their arguments were not convincing from the standpoint for shareholder interests.

If ABC Company is contemplating buying anything for $40 cash (wheat, corn, Microsoft Shares, or ABC treasury shares) and making this part of a future compensation payment in kind, it’s irrelevant how that $40 is paid to an employee because the net cost to ABC Company is $40 in cash. As the proportionate share of ABC Company has not been changed for remaining shareholders whether the payment is salary cash or in treasury shares (which need not be purchased if the salary is to be $40 in cash), the cash cost is the same for the employment services as far as shareholders and the ABC Company are concerned.

ABC Company might feel that payment in ABC’s treasury shares increases the employee’s motivation level. The employee, however, may not view the two alternatives as equivalent since he or she must incur an added transactions cost to convert most any in-kind item into cash.

Your argument would make a little more sense if ABC Company could issue new shares instead of paying $40 in cash. But in most states this is not allowed without shareholder approval due to preemptive anti-dilution protections for existing shareholders that prevent companies from acting like the German government in the wake of World War I (when Germany started printing Deutsch marks that weren’t worth the cost of the paper they were printed on).

It’s very risky to buy shares of corporations that do not have preemptive rights. I think you’ve ignored preemptive rights from get go on this thread.

Bob Jensen

April 17, 2006 message from Gregg Wilson greggwil@optonline.net

Hi Bob Jensen

Maybe you could produce an example of how pooling is "dirty in practice", OTHER THAN the fact that it produces a higher ROI.

Gregg Wilson

April 18, 2006 reply from Bob Jensen

Hi Gregg,

High ROIs are the main reason pooling becomes dirty. It is “dirty” because it is intended to deceive the public and distort future performance measures relative to the underlying economics of the acquisition.

 As to other examples, I think Abe gives you ample illustrations of how management tries to take credit (“feathers in their cap” on Page 494) for “something shareholders are paying dearly for.” Also note his Case II where “A Piddle Makes a Pool.” Briloff, AJ 1967. "Dirty pooling." The Accounting Review (July): 489-496 --- http://www.jstor.org/view/00014826/ap010167/01a00060/0 

Additional examples have been provided over the years by Abe. The following is Table 1 from a paper entitled "Briloff and the Capital Markets" by George Foster, Journal of Accounting Research, Volume 17, Spring 1979 --- http://www.jstor.org/view/00218456/di008014/00p0266h/0
 

As George Foster points out, what makes Briloff unique in academe are the detailed real-world examples he provides. Briloff became so important that stock prices reacted instantly to his publications, particularly those in Barron's. George formally studied market reactions to Briloff articles.

Companies Professor Briloff criticized for misleading accounting reports experienced an average drop in share prices of 8%.

TABLE 1
Articles of Briloff Examined

	Article	Journal/Publication Date	Companies Cited That Are Examined in This Note
1.	"Dirty Pooling"	Barron's (July 15, 1968)	Gulf and Wesern: Ling-Temco-Vought (LTV)
2.	"All a Fandangle?"	Barron's (December 2, 1968)	Leasco Data Processing: Levin-Townsend
3.	"Much-Abused Goodwill"	Barron's (April 28, 1969)	Levin-Townsend; National General Corp.
4.	"Out of Focus"	Barron's (July 28, 1969)	Perfect Film & Chemical Corp.
5.	"Castles of Sand?"	Barron's (February 2, 1970)	Amrep Corp.; Canaveral International; Deltona Corp.; General Development Corp.; Great Southwest Corp.; Great Western United, Major Realty; Penn Central
6.	"Tomorrow's Profits?"	Barron's (May 11, 1970)	Telex
7.	"Six Flags at Half-Mast?"	Barron's (January 11, 1971)	Great Southwest Corp.; Penn Central
8.	"Gimme Shelter"	Barron's (October 25, 1971)	Kaufman & Broad Inc.; U.S. Home Corp.; U.S. Financial Inc.
9.	"SEC Questions Accounting"	Commercial and Financial Chronicle (November 2, 1972)	Penn Central
10.	"$200 Million Question"	Barron's (December 18, 1972)	Leasco Corp.
11.	"Sunrise, Sunset"	Barron's (May 14, 1973)	Kaufman & Broad
12.	"Kaufman & Broad--More Questions?	Commercial and Financial Chronicle (July 12, 1973)	Kaufman & Broad
13.	"You Deserve a Break..."	Barron's (July 8, 1974)	McDonald's
14.	"The Bottom Line: What's Going on at I.T.T." (Interview with Briloff)	New York Magazine (August 12, 1974)	I.T.T.
15.	"Whose Deep Pocket?"	Barron's (July 19, 1976)	Reliance Group Inc.

 Not all of the above illustrations are focused on pooling accounting, but some of them provide real-world examples that you are looking for, particularly dirty pooling at McDonalds Corporation.

 It would would help your case if you followed Briloff’s example by getting out of hypothetical (nonexistent?) examples and give us some real world examples from your consulting. I don’t buy into any illustrations that merely criticize goodwill accounting. What you need to demonstrate how accounting for goodwill under purchase accounting was more misleading than pooling accounting for at least one real-world acquisition. I realize, however, that this may be difficult since the SEC will sue companies who use pooling accounting illegally these days. Did you ever wonder why the SEC made pooling illegal?

Perhaps for your clients you have prepared statements contrasting purchase versus pooling in acquisitions. It would be nice if you could share those (with names disguised).

Bob Jensen

April 17, 2006 reply from Paul Polinski [pwp3@CASE.EDU]

Gregg:
Please let me use a slightly different example to look at your views in the purchase/pooling debate, and invite anyone else to contribute or to improve the example.

Let's say you own and run several bed-and-breakfast inns. About 20 years ago, you received as a gift an authentic Normal Rockwell painting, which you put behind a false wall in your house to protect your investment. You recently brought it back out, and several reputable appraisers have put its value at $255,000.

You want to invest in an inn, and its lot, that the current owner is selling. The current owner bought the inn and lot many years ago for $100,000; the inn's $60,000 gross book value is fully depreciated, while the lot (as land) is still recorded on current owner's books at $40,000. You and another party agree to jointly purchase the inn from the current owner; you exchange your Normal Rockwell painting for 51% ownership in the inn/lot, and the other party pays $245,000 in cash for his or her 49% ownership. You and the other party have rights and responsibilities proportional to your ownership percentages in all aspects under the joint ownership agreement.

To simplify matters, at my own risk, I'll say "ignore tax treatments for now."

My questions to you are:

(1) For performance evaluation purposes, when you and the other party are computing the returns on your respective investments in this inn, what are your relevant investment amounts?

(2) (I'm wandering out on a limb here, so I'll invite anyone who wants to improve or correct this to do so...)

Now let's say that all the other facts are the same, except that:

- The other party pays $122,500 for 49% ownership of the inn/lot;

- You get 51% ownership in the inn/lot in exchange for giving the current owner a 50% transferable ownership interest in your Norman Rockwell.

What are your relevant investment amounts in this case?

Paul

April 18, 2006 message from Gregg Wilson greggwil@optonline.net

Hi Paul Polinski

So what's the point? Your example is clearly a cash acquisition. Pooling is appropriate only in the case of a share exchange acquisition, and I would say pooling should only be used in the case of two ongoing enterprise. The point is that a share exchange acquisition is a combining of equity interests and there is no purchase price beyond the exchange ratio. Say you had two inns and both are ongoing businesses so they not only have real estate assets but furniture and equipment and supplies and payables and receivables etc. Lets say they each have book assets of $40,000 and they decide to combine their two enterprises on a share for share basis. The owner of each inn ends up with half the equity in the combined enterprise. Has a new value been placed on the assets by the share exchange? Would the owners want to restate the assets to some different value just because they have merged? Or would they prefer to retain the combined financial statements as they are? Doesn't the meaningfulness of the earnings model depend on following consistent rules of matching costs and revenues over a period of time, and wouldn't revaluing those costs merely represent an obliteration of the earnings model and the information it imparts? Is not a share exchange acquisition a totally different animal from a cash purchase, and shouldn't it be recorded in the financial statements in a way that reflects that economic reality?

Gregg Wilson

April 19, 2006 reply from Bob Jensen

Sorry Gregg,

You’re too hung up on cash basis accounting. You only think transactions can be valued if and when they are paid in cash. This is clearly absurd since there are many purchase transactions that are not cash deals and require value estimation on the part of both the buyer and the seller. We use value estimates in countless transactions, and accounting would really revert to the dark ages if we were forced to trace value of each item back to some ancient surrogate cash transaction value years ago. Cash accounting can badly mislead investors about risk, such as when interest rate swaps were not even disclosed on financial statements until cash flowed. Our estimates of current values and obligations may be imperfect, but they beat non-estimation.

With respect to business combinations/acquisitions, GAAP requires that the accounting come as close as possible to the value estimations upon which the deal was actually transacted. I don’t know how many times we have to tell you that the valuation estimation process is not perfect, but trying to come as close to economic reality at the time of the current transaction is our goal, not pulling values from transactions from olden times and ancient history circumstances.

Be careful what you declare on this forum, because some students are also in the forum and they may believe such declaratives as “Pooling is appropriate only in the case of a share exchange acquisition.” Pooling is not only a violation of FASB standards, it is against SEC law. Please do not encourage students to break the law.

And there are good reasons for bans on pooling. You’ve not been able to convince a single professor in this forum that pooling is better accounting for stock trades. You’ve ranted against estimates of value and how these estimates may become impaired shortly after deals go down, but GAAP says to do the best job possible in booking the values that were in effect at the time the deals actually went down. If values become impaired later on, GAAP says to adjust the values.

You’ve not convinced a single one of us who watched pooling accounting become dirty time and time again when it was legal. We don’t want to revert to those days of allowing managers to repeatedly report inflated ROIs on acquired companies.

I think Richard Sansing is right. You’re beating a dead horse. Future communications that only repeat prior rants are becoming time wasters in this forum.

Forum members interested in our long and tedious exchange on this topic can go to http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#Pooling 

Bob Jensen

April 18, 2006 message from Gregg Wilson greggwil@optonline.net

Hi Again Bob Jensen

Let's put it this way. If we want to value the acquisition at a non-cost current value, then we should use a fair appraisal like something akin to what a cash buyer would be willing to pay, and not the phoney share exchange value. Then we could actually have goodwill numbers that made some sense and would avoid all those embarassing impairment writedowns a year after the acquisition. I prefer pooling, but if you insist on revaluing, then use an economic value. The value of the exchanged shares is not, I repeat, not an economic value.

Gregg

April 20, 2006 reply from Bob Jensen

Sorry Gregg,

GAAP states that all tangible assets should be valued at what cash purchasers would pay for them, so we have no argument.

Intangibles such as knowledge capital are more difficult to value, but the ideal is to value them for what cash purchasers would pay for such things as a skilled work force, customers, name recognition, etc.

The problem with using a cash price surrogate lies in situations where there is really valuable synergy that is unique to the acquiring company. For example, there is probably considerable synergy value (actually monopoly) value when SBC acquired AT&T that probably made it much more valuable to SBC than to any other buyer whether the deal would be done in cash or stock.

Auditors are supposed to attest to the value at the time the acquisition deal goes down. Not long afterwards it may be found that the best estimate at the time the deal went down was either in error or it was reasonable at the time but the value changed afterwards, possible because of the market impact of the “new” company operating after the acquisition. For example, when Time Warner acquired AOL it appears that Time Warner and its auditors gave up way to much value to AOL in the deal, in part due to accounting fraud in AOL.

Problems of valuation in purchase accounting should not, and cannot under current law, be used as an excuse to use historical cost values that typically have far greater deviation from accurate values at the time the acquisition deal is consummated.

I think you made your points Gregg. Please stop repeating arguments that you have hammered repeatedly at http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#Pooling 

Bob Jensen

April 20, 2006 message reply Gregg Wilson

Hi Bob Jensen

You have masterfully skirted the issue as usual. Do you believe that the value of the exchanged shares is either a "fair value" and/or an "economic value"? If we are attesting to the value at the time of the deal as the share exchange value then I would say we are attesting badly. Use whatever fair value you want. The value of the exchanged shares isn't one.

By the way. AOL purchased Time Warner, not the other way around. From the 10K:

April 20, 2006 Reply from Bob Jensen

Sorry Gregg

I think you're wasting our time and embarrassing yourself until you can back your wild claims with convincing research. Your wild speculations appear to run counter to serious research.

If you are really convinced of evidence to the contrary, please go out and conduct some rigorous research testing your hypotheses. Please don't continue making wild claims in an academic forum until you've got some convincing evidence.

Or as Richard Sansing would say, we seldom accept anecdotal evidence that can be selectively cherry picked to show most any wild speculation.

If you bothered to do research rather than wildly speculate, you would find that serious academic research points to the conclusions opposite to your wild speculations about revaluations and goodwill write-offs.

---

First consider the Steven L. Henning, Wayne H. Shaw, and Toby Stock (2004) study:

This paper investigates criticisms that U.S. GAAP had given firms too much discretion in determining the amount and timing of goodwill write-offs. Using 1,576 U.S. and 563 U.K. acquisitions, we find little evidence that U.S. firms managed the amount of goodwill write-off or that U.K. firms managed the amount of revaluations (write-ups of intangible assets). However, our results are consistent with U.S. firms delaying goodwill write-offs and U.K. firms timing revaluations strategically to avoid shareholder approval linked to certain financial ratios.
Steven L. Henning, Wayne H. Shaw, and Toby Stock, "The Amount and Timing of Goodwill Write-Offs and Revaluations: Evidence from U.S. and U.K. Firms," Review of Quantitative Finance and Accounting, Volume 23, Number 2, September 2004 Pages: 99 - 121

---

Also consider the Ayers, Lefanowicz, and Robinson (2002a) conclusions below:

We investigate two related questions. What factors influence firms' use of acquisition accounting method, and are firms willing to pay higher acquisition premiums to use the pooling-of-interests accounting method? We analyze a comprehensive sample of nontaxable corporate stock-for-stock acquisitions from 1990 through 1996. We use a two-stage, instrumental variables estimation method that explicitly allows for simultaneity in the choice of accounting method and acquisition premiums. After controlling for economic differences across pooling and purchase transactions, our evidence indicates that financial reporting incentives influence how acquiring firms structure stock-for-stock acquisitions. In addition, our two-stage analysis indicates that higher acquisition premiums are associated with the pooling method. In sum, our evidence suggests that acquiring firms structure acquisitions and expend significant resources to secure preferential accounting treatment in stock-for-stock acquisitions.
Benjamin C. Ayers , Craig E. Lefanowicz and John R. Robinson, "Do Firms Purchase the Pooling Method?" Review of Accounting Studies Volume 7, Number 1, March 2002 Pages: 5 - 32.

You apparently have evidence to contradict the Ayers, Lefanowicz, and Robinson (2002a) study. Would you please enlighten us with some convincing evidence.

---

Consider the Patrick E. Hopkins, Richard W. Houston, and Michael F. Peters (2000) research:

We provide evidence that analysts' stock-price judgments depend on (1) the method of accounting for a business combination and (2) the number of years that have elapsed since the business combination. Consistent with business-press reports of managers' concerns, analysts' stock-price judgments are lowest when a company applies the purchase method of accounting and ratably amortizes the acquisition premium. The number of years since the business combination affects analysts' price estimates only when the company applies the purchase method and ratably amortizes goodwill—analysts' price estimates are lower when the business-combination transaction is further in the past. However, this joint effect of accounting method and timing is mitigated by the Financial Accounting Standards Board's proposed income-statement format requiring companies to report separate line items for after-tax income before goodwill charges and net-of-tax goodwill charges. When a company uses the purchase method of accounting and writes off the acquisition premium as in-process research and development, analysts' stock price judgments are not statistically different from their judgments when a company applies pooling-of-interest accounting.
Patrick E. Hopkins, Richard W. Houston, and Michael F. Peters, "Purchase, Pooling, and Equity Analysts' Valuation Judgments," The Accounting Review, Vol. 75, 2000, 257-281.

---

You seem to think that acquisition goodwill is based upon wild speculation. Research studies discover rather sophisticated valuation approaches that distinguish core from synergy goodwill components. See Henning, Lewis, and Shaw, "Valuation of Components of Purchased Goodwill," The Journal of Accounting Research, Vol. 38, Autumn 2000.

---

Also consider the Ayers, Lefanowicz, and Robinson (2002b) study: 

Accounting standard setters have become increasingly concerned with the perceived manipulation of financial statements afforded by the pooling-of-interests (pooling) method of accounting for corporate acquisitions. While different restrictions have been discussed, in September 1999 the Financial Accounting Standards Board (FASB) issued an Exposure Draft to eliminate the pooling method. This study provides a basis for evaluating restrictions on the pooling method by analyzing the financial statement effects on pooling acquisitions made by public corporations over the period 1992 through 1997. Using these acquisitions we (1) quantify the scope of the pooling problem, (2) estimate the financial statement repercussions of eliminating the pooling method, and (3) examine the effects of restricting pooling accounting to business combinations meeting various merger of equals restrictions.

While our analysis does not address whether restrictions on the pooling method will influence the nature or level of acquisition activity, the results indicate that the pooling method generates enormous amounts of unrecognized assets, across individual acquisitions, and in aggregate. In addition, our results suggest that recording and amortizing these assets generate significant balance sheet and income statement effects that vary with industry. Regarding restrictions on the pooling method, our analysis indicates that size restrictions would significantly reduce the number and value of pooling acquisitions and unrecognized assets generated by these acquisitions.

. . .

Accounting standard setters have become increasingly concerned with the perceived manipulation of financial statements and the lack of comparability across firms financial statements that have resulted from having two acquisition accounting methods. Consistent with these concerns, the FASB issued an Exposure Draft in September 1999 to eliminate the pooling-of-interests method. Using a comprehensive set of pooling acquisitions by public corporations over the period 1992 through 1997, this study analyzes the financial statement effects of eliminating or severely restricting the pooling method of accounting for business combinations. Although we make no assumptions regarding the effects of pooling restrictions on either acquisition activity or acquisition price, this study provides a useful starting point for assessing the effects of different pooling restrictions. Our evidence suggests that firms avoid recognition of significant amounts of target firms purchase prices, both in aggregate and per acquisition, via the pooling method. Further, we document that these unrecognized assets are significant relative to the bidders book value and that the quantity and dollar magnitude of pooling acquisitions have increased dramatically in recent years. With respect to industry-specific analyses, we find that the financial services industry accounts for approximately one-third of all pooling acquisitions in number and value.

The effects on bidder financial-reporting ratios of precluding use of the pooling method for a typical acquisition are substantial, though varying widely across industries. Decreases in return on equity, assuming a ten-year amortization period for unrecognized assets, range from a 65 percent decline for the hotel and services industry to a13 percent decline for the financial services industry.15For earnings per share, the effects are more moderate than are those on return on equity. Decreases, assuming a ten-year amortization period, range from a 42 percent decrease for the food, textile, and chemicals industry to an 8 percent decrease for the financial services industry. For market-to-book ratios, four industries (the metal and mining industry; the food, textile, and chemicals industry; the hotel and other services industry; and the health and engineering industry) have decreases in bidder market-to-book ratio in excess of 30 percent, whereas the financial services industry has only a 6 percent decrease. The relatively small effects for the financial services industry suggests that the industry�s opposition to eliminating the pooling method may be more driven by the quantity and aggregate magnitude of pooling acquisitions than per-acquisition effects. Overall, we find that eliminating the pooling method affects firm profitability and capitalization ratios in all industries, but there is a wide dispersion of the magnitude of these effects across industry.

Finally, we document that restricting pooling treatment via a relative size criterion significantly decreases the number and value of pooling acquisitions as well as the unrecognized assets generated by these acquisitions. Nevertheless, we find that a size restriction, depending on its exact implementation, can simultaneously allow a number of acquisitions to be accounted for under the pooling method. Regardless of the type of restriction, the magnitude of past pooling transactions, both in total dollars and relative to the individual bidder's financial condition, lends credibility to the contention that the imposition of pooling restrictions has the potential to seriously impact firm financial statements and related financial-reporting ratios. These effects, of course, decrease with a longer amortization period for unrecognized assets.
Benjamin C. Ayers , Craig E. Lefanowicz and John R. Robinson, "The Financial Statement Effects of Eliminating the Pooling-of-Interests Method of Acquisition," Accounting Horizons, Vol 14, March 2000.

---

There are many, many more such studies. If you are really convinced of evidence to the contrary, please go out and conduct some rigorous research testing your hypotheses. Please don't continue this until you've got some convincing evidence.

Or as Richard Sansing would say, we seldom accept anecdotal evidence that can be selectively cherry picked to show most any wild conclusion.

Nobody argues that the present system of accounting for acquisitions and goodwill is perfect. Various alternatives have been proposed in the research literature. But none to my knowledge support your advocacy of a return to pooling-of-interests accounting.

Bob Jensen

PS
You are correct about the AOL purchase of Time Warner. I forgot this since Time Warner runs the household. Later on it was Time Warner that tried to sell AOL (to Google). It's a little like husband buys wife and later on wife puts husband for sale.

April 18, 2006 message from Gregg Wilson greggwil@optonline.net

Hi Bob Jensen

I was really trying to go one step at a time, and establish that the value of the exchanged shares is not an economic value or a "fair appraisal" of the value of the acquired company. I am certainly not a researcher, and as you know I do not have access to the fine studies that you have referenced. I am not even sure what would qualify as evidence of the point.

I was thinking one could send the following questionnaire to companies that had made share exchange acquistions....

""""""""""" You recently made a share exchange for XYZ company. After you determined the value of the target company to you, [Target value], which of the following do you feel best describes the decision process by which you arrived at the number of shares to offer the target company:

(1) [Target value] / [Price of your stock]

(2) [Your shares outstanding] * ([Target value] / [Your value]) where [Your value] is the value of your own company arrived at by a similar valuation standard as [Target value].

(3) Some combination of the above, or other decision process. Please explain________________________________.

""""""""""""""""

If the response came back overwhelmingly (2), then would that be conclusive evidence that the value of the exchanged shares is not an economic value or the price paid? I really wouldn't want to go to the trouble, if the result wouldn't demonstrate what I am trying to demonstrate.

Gregg Wilson

April 23, 2006 reply from Bob Jensen

Sorry Gregg,

If you want to communicate with the academy you must play by the academy’s rules. The number one rule is that a hypothesis must be supported by irrefutable (normative) arguments or convincing empirical evidence. We do accept idle speculation but only for purposes of forming interesting hypotheses to be tested later on.

In my communications with you regarding pooling-of-interests accounting, I've always focused on what I will term your Pooling-Preferred Hypothesis or PP Hypothesis for short. Your hypothesis may be implied from a collection of your earlier quotations from http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#Pooling

Well I would call that entire FAS 141 a lot of sophistries. This is a case of trying to make an apple into an orange and getting a rotten banana.
Gregg Wilson, March 30, 2006

I certainly didn't mean to imply that cash acquisitions should be treated as pooling-of-interest. On the contrary I was trying to make the point that they are totally different situations, and can't be treated effectively by the same accounting rule. The cash is the whole point.
Gregg Wilson, March 30, 2006

Pooling of interest is terrific, because it recreates that earnings model history for the combined companies. The historical costs are not meaningless to the negotiations but rather are the basis for the negotiations, for they are the evidence that the companies are using to determine the share exchange ratio that they will accept.
Gregg Wilson, March 30, 2006

Pooling is appropriate only in the case of a share exchange acquisition, and I would say pooling should only be used in the case of two ongoing enterprise(s).
Gregg Wilson, March 30, 2006

There's a bit of inconsistency in your quotations, because in one case you say pooling is "terrific" for combined companies and in the other quotation you claim pooling should only when the acquired company carries on by itself. I will state your Pooling-Preferred (PP) Hypothesis as follows:

Pooling-Preferred (PP) Hypothesis
FAS 141 is based upon sophistry. Pooling-of--interest accounting is the best accounting approach when a company is acquired in a stock-for-stock (non-cash) acquisition. Purchase accounting required under FAS 141 is a "case of trying to make an apple into an orange and getting a rotten banana. "

What I've tried to point out all along is that FAS 141 is not based upon sophistry. It rests on the foundation of countless normative and empirical studies that refute your PP Hypothesis.

Your only support of the PP Hypothesis is another hypothesis that is stated by you over and over ad nausea for two months as follows:

Exchanged Shares Non-Value (ESNV) Hypothesis
The value of the exchanged shares is not an economic value or a "fair appraisal" of the value of the acquired company. 
Gregg Wilson, April 22, 2006

In the academy we cannot accept an untested hypothesis as a legitimate test of another hypothesis. Even if we speculate that the ESNV Hypothesis is true, it does not support your PP Hypothesis because it is totally disconnected to the real reason that standard setters and the academic academy no longer want pooling accounting. The "real reason" is that corporations are motivated to want pooling accounting so they can inflate future ROIs and make most all acquisitions look like great deals even though some of them are bad deals from an economic perspective (to say nothing about wanting inflated ROIs to support larger bonuses and sweetened future compensation plans for executives).

The preponderance of academic research refutes the PP Hypothesis. One of the highlight studies in fact shows that managers may enter into worse deals (in the past when it was legal) just to get pooling accounting.

Some of the Ayers, Lefanowicz, and Robinson (2002a) conclusions are as follows:

We investigate two related questions. What factors influence firms' use of acquisition accounting method, and are firms willing to pay higher acquisition premiums to use the pooling-of-interests accounting method? We analyze a comprehensive sample of nontaxable corporate stock-for-stock acquisitions from 1990 through 1996. We use a two-stage, instrumental variables estimation method that explicitly allows for simultaneity in the choice of accounting method and acquisition premiums. After controlling for economic differences across pooling and purchase transactions, our evidence indicates that financial reporting incentives influence how acquiring firms structure stock-for-stock acquisitions. In addition, our two-stage analysis indicates that higher acquisition premiums are associated with the pooling method. In sum, our evidence suggests that acquiring firms structure acquisitions and expend significant resources to secure preferential accounting treatment in stock-for-stock acquisitions.
Benjamin C. Ayers , Craig E. Lefanowicz and John R. Robinson, "Do Firms Purchase the Pooling Method?" Review of Accounting Studies Volume 7, Number 1, March 2002 Pages: 5 - 32.

In fact the above study suggests that pooling accounting creates a worse situation that you speculate in your ESNV Hypothesis. My conclusion is that if we accept your ESNV hypothesis we most certainly would not want pooling accounting due to the above findings of Ayers, Lefanowicz, and Robinson.

Your alleged support of the PP Hypothesis is your untested ESNV Hypothesis. As mentioned above, you cannot support a hypothesis with an untested hypothesis. Certainly the academy to date has not accepted your ESNV Hypothesis. And even if it did, this hypothesis alone is disconnected to the academic research pointing to why pooling accounting deceives investors.

Your only support of the ESNV Hypothesis lies in conclusions drawn based upon your own anecdotal experiences. Anecdotal experience is not an acceptable means of hypothesis testing in the academy. Anecdotal evidence can be cherry picked to support most any wild speculation.

As a result, I recommend the following"

1. Admit that you do not have sufficient evidence to support your PP Hypothesis. You must otherwise refute a mountain of prior academic evidence that runs counter to the PP Hypothesis.
   
    

2. Admit that you do not have sufficient evidence in the academic world to support your ESNV hypothesis. Certainly you've not convinced, to my knowledge, any members of this academic (AECM) forum that virtually all managers are so ignorant of values when putting together stock-for-stock acquisitions.
   
    

3. Stop hawking and repeating your anecdotal speculations that are already documented on the Web at http://faculty.trinity.edu/rjensen//theory/00overview/theory01.htm#Pooling
   Come back to us only when you have sufficient academic evidence to support your hypotheses.

April 22, 2006 reply from Henry Collier [henrycollier@aapt.net.au]

You have been very gentle with Gregg Wilson … I would suggest that we send him to Singapore and subject him to the cane that is so liberally used there to the recalcitrant. He has ‘convinced’ not one it seems. Many of us ‘old timers’ agree with you … perhaps Wilson just doesn’t get it … or perhaps it’s his Warhol’s 15 minutes of fame (or infamy in this case).

One comment that has always struck me as relevant in business combinations … well perhaps 2 … (1) why would we revalue only the acquired company’s assets to FMV in the combination and (2) why would we bother to recognize ‘goodwill’ at all? In the recognition it seems as though we’ve just ‘paid’ too much for the FMV of the assets … why wouldn’t we just reduce the ‘retained earnings’ of the combination?

Just my old management accountant’s rant I suppose. Over the years with my approach to the share markets, I’ve found ‘income statements’ and ‘balance sheets’ somewhat less than useful … seems to me that particularly in high risk companies, like pink sheet things being offered / touted on certain websites and through phishing mails, one can obtain both historical and pro-forma I/S and B/S, but seldom any real or projected cash flow information.

With regards from the land down under …

Enjoy retirement, I’ve found it very rewarding … thanks for all you’ve done for the profession …

Henry Collier

April 23, 2006 reply from  [Richard.C.Sansing@DARTMOUTH.EDU] --

Bob,

---Bob Jensen wrote:

In my communications with you (Gregg Wilson) regarding pooling-of-interests accounting, I've always focused on what I will term your Pooling-Preferred Hypothesis or PP Hypothesis for short.

---

My exchanges with Gregg Wilson suggests that his discomfort with GAAP goes well beyond the pooling vs. purchase debate. He does not care for the GAAP treatment of simple transactions such as the transfer of shares to employees in lieu of cash compensation. Why argue about (relatively) complicated transactions with someone who does not understand simple ones?

Richard Sansing

Strange as it may seem a losing company may have more value to someone else than itself

From The Wall Street Journal Accounting Weekly Review on April 27, 2006

TITLE: Alcatel Stands to Reap Tax Benefit on Merger
REPORTER: Jesse Drucker and Sara Silver
DATE: Apr 26, 2006
PAGE: C3
LINK: http://online.wsj.com/article/SB114601908332236130.html 
TOPICS: Accounting, International Accounting, Net Operating Losses, Taxation

SUMMARY: "Lucent's operating losses in [the] wake of [the] tech bubble may allow big deductions" for the merged firm's U.S. operations.

QUESTIONS:
1.) What is the purpose of allowing net operating losses (NOLs) to be deducted against other years' income amounts?

2.) Summarize the U.S. tax law provisions regarding NOLs. Why has Lucent been unable to use up all of its NOL carryforwards since the tech bubble burst in 2000-2001?

3.) Define the term deferred tax assets. Describe how NOLs fit the definition you provide. What other types of deferred tax assets do you think that Lucent has available and wants to take advantage of?

4.) How is it possible that the "federal, state and local deductions" from the deferred tax assets described in answer to question #3 "will nearly double the U.S. net income that the combined company [of Alcatel and Lucent Technologies] will be able to report"?

5.) How does the availability of NOL carryforwards, and the expected timing of their deductions based on an acquirer's earnings or the recent tax law change referred to in the article, impact the price an acquirer is willing to pay in a merger or acquisition transaction?

6.) How did the availability of deferred tax asset deductions drive Alcatel's choice of its location for its headquarters? What other factors do you think drive such a choice?

Reviewed By: Judy Beckman, University of Rhode Island

From The Wall Street Journal Weekly Accounting Review on April 7, 2006

TITLE: Takeover of VNU to Begin with Explanation of Price
REPORTER: Jason Singer
DATE: Apr 03, 2006
PAGE: A2
LINK: http://online.wsj.com/article/SB114405567166415142.html 
TOPICS: Accounting, Mergers and Acquisitions

SUMMARY: The article offers an excellent description of the process undertaken by VNU's Board of Directors in deciding to put the company "on the auction block", consider alternative strategies, and finally accept an offer price.

QUESTIONS:
1.) Describe the transaction agreed to by the Board of VNU NV and its acquirer, AlpInvest Partners.

2.) What does the current stock price of VNU imply about the takeover transaction? Why do you think that VNU is distributing the 210 page document explaining the transaction and the Board's decision process?

3.) Connect to the press release dated March 8 through the on-line version of the article. Scroll down to the section covering the "background of the offer." Draw a timeline of the events, using abbreviations that are succinct but understandable.

4.) What other alternatives did the VNU Board consider rather than selling the company? Why did they decide against each of these alternatives?

5.) Based on the information in the article and the press releases, do you think the acquirers will obtain value from the investment they are making? Support your answer, including refuting possible arguments against your position.

Reviewed By: Judy Beckman, University of Rhode Island

"Takeover of VNU to Begin With Explanation of Price," by Jason Singer, The Wall Street Journal, April 3, 2006 --- http://online.wsj.com/article/SB114405567166415142.html 

A group of private-equity funds is beginning a $9 billion takeover of Dutch media giant VNU NV with the release of documents that explain for the first time how VNU's board determined the purchase price was high enough.

In the four weeks since VNU announced it would recommend the private-equity group's offer, many shareholders have accused the company of rushing to sell itself after being forced by investors to abandon a big acquisition last year.

These critics said that the sale process was halfhearted and that the agreed-upon price too low. Some have said they preferred VNU to break itself up and separately sell the pieces.

At least two VNU shareholders, including mutual-fund giant Fidelity Investments, have said publicly they are unlikely to support the takeover; many others have said so privately.

VNU shares have traded far below the agreed per-share offer price of €28.75 ($34.85) since the deal was announced, suggesting the market expects the takeover bid to fail.

VNU – based in Haarlem, Netherlands, and the world's largest market-research firm by sales – addresses these concerns in the 210-page offer document to be sent to shareholders and outlines in detail the steps it took to ensure the highest value.

Materials include two fairness opinions written by VNU's financial advisers, one by Credit Suisse Group and the other by NM Rothschild & Sons, evaluating the offer and concluding the price is attractive for shareholders.

"This was a fully open auction," said Roger Altman, chairman of Evercore Partners, another VNU financial adviser. The company's board fully vetted all options, including a breakup of the business, restructuring opportunities or proceeding with the status quo, he said. "None provided a value as high as €28.75 [a share]. None of them."

Mr. Altman said that after being contacted by private-equity funds interested in buying VNU after its failed attempt last year to acquire IMS Health Inc., of Fairfield, Conn., VNU auctioned itself, including seeking other strategic or private-equity bidders.

A second group of private-equity funds explored a possible bid but dropped out when it concluded it couldn't pay as much as the first group said it was prepared to offer. Another potential bidder, a company, withdrew after refusing to sign a confidentiality agreement, VNU's offer document says.

The initial group, which submitted the only firm bid, consists of AlpInvest Partners of the Netherlands, and Blackstone Group, Carlyle Group, Hellman & Friedman, Kohlberg Kravis Roberts & Co. and Thomas H. Lee Partners, all of the U.S. The group formed Valcon Acquisition BV to make the bid.

Some of the calculations provided in the offer document suggest the company might be valued higher than the Valcon bid price in certain circumstances. The Credit Suisse letter indicates the company could be valued at as much as €29.60 a share based on prices paid for businesses similar to VNU's in the past. It says a "sum of the parts breakup analysis" indicates a range of €25.90 to €29.35.

The Rothschild letter also shows certain methods of valuing the company reaching as high as €35.80 a share. But both advisers said that when weighed against the many risks in VNU's future, the cash payment being offered now by the Valcon group is the most attractive option for shareholders.

COMPANIES

Dow Jon

VNU N.V. (38987.AE)

PRICE CHANGE

27.49 0.06 8:25a.m.

 
 

Cadbury Schweppes PLC ADS (CSG)

PRICE CHANGE

40.10 0.07 4/6

 
 

IMS Health Inc. (RX)

PRICE CHANGE

25.99 0.02 4/6

 

From The Wall Street Journal Weekly Accounting Review on April 7, 2006

TITLE: Sign of the Times: A Deal for GMAC by Investor Group
REPORTER: Dennis K. Berman and Monica Langley
DATE: Apr 04, 2006
PAGE: A1 LINK: http://online.wsj.com/article/SB114406446238015171.html 
TOPICS: Accounting, Advanced Financial Accounting, Banking, Bankruptcy, Board of Directors, Financial Accounting, Investments, Mergers and Acquisitions, Spinoffs

SUMMARY: Cerberus Capital Management LP has led the group who will acquire control of General Motors Acceptance Corp. (GMAC) from GM for $7.4 billion (plus an additional payment from GMAC to GM of $2.7 billion). GM had expected to receive offers for GMAC from big banks. Instead, they received offers from private-equity and hedge funds, like the one from Cerberus. This article follows up on last week's coverage of this topic; the related article identifies how CEO Rick Wagoner is working with his Board to extend time for evaluating his own performance there.

QUESTIONS:
1.) Describe the transaction GM is undertaking to sell control in GMAC. Specifically, who owns the 51% ownership of GMAC that is being sold? What will happen to the 49% ownership in GMAC following this transaction? To answer the question, you may also refer to the GM statement available through the on-line article link at http://online.wsj.com/article/SB114406559238215183.html 

2.) Again refer to the GM statement on the GMAC deal. In addition to the purchase price, what other cash flows will accrue to GM from this transaction? How do you think these items relate to the fact that GM is selling a 51% interest in GMAC?

3.) What is the nature of GMAC's business? Specifically describe its "portfolio of loans and lease receivables."

4.) Why do you think GM expected "...be courted by big banks..." to negotiate a purchase of GMAC? Why do you think that expectation proved wrong, that other entities ended up bidding for GMAC? To answer, consider the point made in the article that even Citigroup, GM's primary bank and a significant player in the ultimate deal, had decided that it couldn't structure a deal that GM wanted from big banks.

5.) What are the risks associated with the acquisition of GMAC? In particular, comment on the risk associated with GM's possible bankruptcy and its relation to GMAC's business operations.

Reviewed By: Judy Beckman, University of Rhode Island

--- RELATED ARTICLES ---
TITLE: GM's Wagoner Gains Some Time for Turnaround
REPORTER: Lee Hawkins, Jr., Monica Langley, and Joseph B. White
PAGE: A1
ISSUE: Apr 04, 2006
LINK: http://online.wsj.com/article/SB114411090537615994.html

Advanced Accounting
How should a 34% equity interest be reported?

Coke Near Deal for Bottler
by: Dana Cimilluca, Betsy McKay and Jeffrey McCracken
Feb 25, 2010
Click here to view the full article on WSJ.com
Click here to view the video on WSJ.com 

TOPICS: Advanced Financial Accounting, Consolidations, Investments, Mergers and Acquisitions

SUMMARY: "In a strategic about-face driven by big changes in consumer tastes, Coca-Cola Co. was nearing a deal late Wednesday to buy the bulk of its largest bottler, according to people familiar with the matter." The companies reached agreement on the transaction and by Friday the WSJ reported a fall in Coke share prices and a gain on the share values of its bottler, Coca-Cola Enterprises (CCE).

CLASSROOM APPLICATION: The article is useful to discuss corporate strategy leading to equity method investments versus ownership and control.

QUESTIONS: 
1. (Introductory) What was the reasoning that Coca-Cola's strategic organization for decades was based on "setting up large, independent bottlers run separately from Atlanta-based Coke itself"? What does Coke itself now sell?

2. (Advanced) How did Coke resolve concerns about losing control over its bottling companies even as it kept "the bottlers' assets off its books"? Why is this desirable for Coke?

3. (Advanced) How do you think that Coke accounts for its "34% stake as of the end of last year" in its largest bottler, Coca-Cola Enterprises (CCE)?

4. (Advanced) What are the strategic reasons that Coke is now reacquiring its North American bottling operations? How is the transaction being structured?

5. (Introductory) Refer to the related article. How did markets react to the closure of this deal?

Reviewed By: Judy Beckman, University of Rhode Island

RELATED ARTICLES: 
Coca-Cola Fizzles, But Dr. Pepper Pops
by Kristina Peterson
Feb 26, 2010
Page: C5

News Hub: Coke's New Deal
by
Feb 25, 2010
Online Exclusive

Minority Interests:  Lambs being led to slaughter?

From The Wall Street Journal Accounting Weekly Review on June 11, 2009

Investors Missing the Jewel in Crown
by Martin Peers
The Wall Street Journal
Jun 06, 2009
Click here to view the full article on WSJ.com
http://online.wsj.com/article/SB124425049774290141.html?mod=djem_jiewr_AC

TOPICS: Advanced Financial Accounting, Consolidations, Debt, Financial Accounting, Financial Analysis

SUMMARY: The article assesses the situation of two companies associated with financial difficulties: Crown Media, 67% owned by Hallmark Cards, and Clear Channel Outdoor, 89% owned by Clear Channel Media. In the latter case, the entity in financial difficulty is the owner company. Questions ask students to look at a quarterly filing by Crown Media, to consider the situation facing noncontrolling interest shareholders, and to understand the use of earnings multiplier analysis for pricing a security.

CLASSROOM APPLICATION: The article is good for introducing the interrelationships between affiliated entities when covering consolidations. It also covers alternative calculations of, and analytical use of, a P/E ratio.

QUESTIONS: 
1. (Introductory) Access the Crown Media 10-Q filing for the quarter ended March 31, 2009 at http://www.sec.gov/Archives/edgar/data/1103837/000110383709000008/mainform5709.htm Alternatively, click on the live link to Crown Media in the WSJ article, click on SEC Filings in the left hand column, then choose the 10-Q filing made on May 7, 2009. Describe the company's financial position and results of operations.

2. (Advanced) Crown Media's majority shareholder is Hallmark Cards "which also happens to be its primary lender to the tune of a billion dollars...." Where is this debt shown in the balance sheet? How is it described in the footnotes? When is it coming due?

3. (Advanced) What has Hallmark Cards proposed to do about the debt owed by Crown Media? What impact will this transaction have on the minority Crown Shareholders?

4. (Advanced) Do you think the noncontrolling interest shareholders in Crown Media can do anything to stop Hallmark Cards from unilaterally implementing whatever changes it desires? Support your answer.

5. (Introductory) Refer to the description of Clear Channel Outdoor. How is the company's share price assessed? In your answer, define the term "price-earnings ratio" or P/E ratio and explain the two ways in which this is measured.

6. (Advanced) What does the author mean when he writes that "anyone buying Outdoor stock should remember that" the existence of a majority shareholder with significant debt holdings also could pose problems for an investment?

Reviewed By: Judy Beckman, University of Rhode Island

"Investors Missing the Jewel in Crown," by Martin Peers, The Wall Street Journal, June 5, 2009 ---
http://online.wsj.com/article/SB124425049774290141.html?mod=djem_jiewr_AC

Investing in a company controlled by its primary lender can be hazardous. Just ask shareholders in Crown Media.

Owner of the Hallmark TV channel, Crown is 67%-owned by Hallmark Cards, which also happens to be its primary lender to the tune of a billion dollars. With the debt due next year, Hallmark on May 28 proposed swapping about half of its debt for equity, which would massively dilute the public shareholders. Crown's stock, long supported by hope that the channel would get scooped up by a big media company, is down 36% since then.

Helping feed outrage among some shareholders was the fact that the swap proposal comes as the Hallmark Channel was making inroads with advertisers. Profits were on the horizon.

Clear Channel Outdoor holds parallels. The billboard company owes $2.5 billion to Clear Channel Media, its 89% shareholder, a fraught situation for Outdoor's public holders.

In this case, of course, the parent is in financial distress. Hence the significance of Outdoor's contemplation of refinancing options, which could lead to the loan being repaid. The hope among some investors is that events conspire to prevent that, forcing the parent into bankruptcy and putting Outdoor up for auction.

That could bail out shareholders. At $6.36 a share at Friday's close, Outdoor's enterprise value is roughly 9.8 times projected 2009 earnings before interest, taxes, depreciation and amortization, below Lamar Advertising's 10.9 times multiple. Using 2010 projections and an equivalent multiple implies a share price above $10.

But as Crown showed, the interests of a majority shareholder who doubles as a lender don't necessarily coincide with minority holders. Anyone buying Outdoor stock should remember that.

Bob Jensen's threads on corporate governance are at
http://faculty.trinity.edu/rjensen/fraud001.htm#Governance

Bob Jensen's Rotten to the Core threads
http://faculty.trinity.edu/rjensen/FraudRotten.htm

Event Study --- http://en.wikipedia.org/wiki/Event_study

From The Wall Street Journal Weekly Accounting Review on May 11, 2012

Earnings Surprises Lose Punch
by: Spencer Jakab
May 07, 2012
Click here to view the full article on WSJ.com
Click here to view the video on WSJ.com 
 

TOPICS: Earning Announcements, Earnings Forecasts, Earnings Management, Regulation

SUMMARY: "Companies and the analysts who cover them typically set the [earnings expectations] bar low enough that a 'beat' has to be substantial, and not marred by unpleasant news about the outlook, to really have an impact." The article shows that the 20 year average proportion of firms beating the consensus of analysts' estimates is 58% each quarter, while the proportion for firms reporting their calendar first quarter of 2012 is 70%. From 1993 through 2001, about half of companies had positive earnings surprises, "which seems natural."

CLASSROOM APPLICATION: The article is useful to introduce earnings forecasts in any financial accounting class.

QUESTIONS: 
1. (Advanced) What does it mean to say that a company may "meet or beat" earning expectations? In your answer, define who sets these expectations.

2. (Introductory) What was the average proportion of firms who met or beat the consensus forecasts of analysts following their firms for the first calendar quarter of 2012?

3. (Advanced) What was the percentage of firms who beat earnings forecasts from 1993 to 2001? Why should that result "seem natural"?

4. (Advanced) What is the overall pattern of analysts' estimates? Why do you think this pattern emerges? How does it lead to the conclusion that "the important statistic is actual corporate profits"?

5. (Introductory) What is the SEC's Regulation Fair Disclosure? (Hint; you may search on the SEC's web site at www.sec.gov to investigate this question.) According to the article, how does the implementation of Regulation FD impact the earnings forecasting process?
 

Reviewed By: Judy Beckman, University of Rhode Island

 

"Earnings Surprises Lose Punch," by Spencer Jakab, The Wall Street Journal, May 7, 2012 ---
http://online.wsj.com/article/SB10001424052702304020104577384304200945934.html?mod=djem_jiewr_AC_domainid

Gomer Pyle might have been about as competent an equity strategist as he was a marine. While the knee-jerk reaction to a positive earnings surprise is often, well, positive, gains can be fleeting. The reason is that companies and the analysts who cover them typically set the bar low enough that a "beat" has to be substantial, and not marred by unpleasant news about the outlook, to really have an impact.

Take the current earnings season. Now that a little over four-fifths of S&P 500 companies by market value have reported, Brown Brothers Harriman says 70% of those have beaten estimates. But since Alcoa Inc. informally kicked off the current reporting season April 10, the S&P 500 is down slightly.

While this "positive surprise ratio" of 70% is above the 20 year average of 58% and also higher than last quarter's tally, it is just middling since the current bull market began in 2009. In the past decade, the ratio only dipped below 60% during the financial crisis. Look before 2002, though, and 70% would have been literally off the chart. From 1993 through 2001, about half of companies had positive surprises, which seems natural.

What changed? One potential reason is the tightening of rules governing analyst contacts with management. Analysts now must rely on publicly available guidance or, gasp, figure things out by themselves. That puts companies, with an incentive to set the bar low so that earnings are received positively, in the driver's seat. While that makes managers look good short-term, there is no lasting benefit for buy-and-hold investors. In fact, an October study by CXO Advisory Group found that the average weekly index return during earnings season has been slightly negative since 2000, while it has been positive for the rest of the year.

The important statistic is actual corporate profits. BBH estimates the S&P 500 recorded operating earnings of $25.31 a share last quarter. That is about $1.50 higher than analyst consensus estimates a month ago but around $1.00 below last July's estimate. That is a typical pattern as expectations start out too optimistic and, by the time actual earnings approach, are too low. When the ink is dry, though, actual profits rarely make it to where expectations first began.

As Gomer would exclaim: "Well gaw-lee."

From The Wall Street Journal Accounting Weekly Review on September 3, 2010

The Decline of the P/E Ratio
by: Ben Levisohn
Aug 30, 2010
Click here to view the full article on WSJ.com
Click here to view the video on WSJ.com 

TOPICS: Analysts' Forecasts, Financial Statement Analysis, Forecasting

SUMMARY: "While U.S. companies announced record profits during the second quarter, and beat forecasts by a comfortable 10% margin, on average, the stock market has dropped 5%. Based on trailing 12-month earnings, the average price earnings (P/E) ratio in the overall market is about 14.9 compared to 23.1 in September 2009; "based on profit expectations over the next 12 months, the P/E ratio has fallen to 12.2 from about 14.5 in May, 2010." The reason for this divergence is, of course, economic uncertainty that is not evident in the (average) point estimates of earnings nor in the relatively good earnings numbers of both the first and second calendar quarters of 2010. The related article is a WSJ graphic of earnings per share actual compared to average analyst estimates, by industry and by week.

CLASSROOM APPLICATION: The article is useful to show the need for understanding context of ratios in undertaking financial statement analysis. It also demonstrates that ratios can be measured in more than one way, such as the use of past earnings or analysts' average forecasts. The related article can be used to introduce students to analysts' earnings forecasts.

QUESTIONS: 
1. (Introductory) Define the price earnings ratio (P/E) and explain its meaning.

2. (Introductory) What two methods of measuring P/E are described in the article? Why do you think both are used?

3. (Introductory) Refer to the related article. How are analysts' estimates used in this WSJ graphic analysis? In your answer, also describe who are the analysts producing these estimates.

4. (Advanced) How did companies perform relative to analysts' estimates in the second calendar quarter of 2010?

5. (Advanced) What has happened to the P/E ratio? Why does the author say the P/E has fallen in relevance? Do you agree with that assessment?

6. (Introductory) What other evidence in the article corroborates the issues in the recent fall in the average P/E ratio?

Reviewed By: Judy Beckman, University of Rhode Island

RELATED ARTICLES: 
Now Reporting: Earnings
by
Aug 01, 2010
Online Exclusive

"The Decline of the P/E Ratio," by: Ben Levisohn, The Wall Street Journal, August 30, 2010 ---
http://online.wsj.com/article/SB10001424052748703618504575459583913373278.html?mod=djem_jiewr_AC_domainid

As investors fixate on the global forces whipsawing the markets, one fundamental measure of stock-market value, the price/earnings ratio, is shrinking in size and importance.

And the diminution might not stop for a while.

The P/E ratio, thrust into prominence during the 1930s by value investors Benjamin Graham and David Dodd, measures the amount of money investors are paying for a company's earnings. Typically, companies that post strong earnings growth enjoy richer stock prices and fatter P/E ratios than those that don't.

But while U.S. companies announced record profits during the second quarter, and beat forecasts by a comfortable 10% margin, on average, the stock market has dropped 5% this month.

The stock market's average price/earnings ratio, meanwhile, is in free fall, having plunged about 36% during the past year, the largest 12-month decline since 2003. It now stands at about 14.9, compared with 23.1 last September, based on trailing 12-month earnings results. Based on profit expectations over the next 12 months, the P/E ratio has fallen to 12.2 from about 14.5 in May.

So what explains the contraction? In short, economic uncertainty. A steady procession of bad news, from the European financial crisis to fears of deflation in the U.S., has prompted analysts to cut profit forecasts for 2011.

"The market is worrying not just about a slowdown, but worse," said Tobias Levkovich, chief U.S. equity strategist at Citigroup Global Markets in New York. "People want clarity before they make a decision with their money."

Three months ago, analysts expected the companies in the Standard & Poor's 500-stock index to boost profits 18% in 2011. Now, they predict 15%. Mutual-fund, hedge-fund and other money managers put the increase at closer to 9%, according to a recent Citigroup survey, while Mr. Levkovich's estimate is for 7% growth.

"The sustainability of earnings is in doubt," said Howard Silverblatt, an index analyst at S&P in New York. "Estimates are still optimistic."

Equally troublesome, analysts' forecasts are becoming scattered. In May, the range between the highest and lowest analyst forecasts of S&P 500 earnings per share in 2011 was $12. Morgan Stanley predicted $85 per share, while UBS predicted $97 per share. Now, the spread is $15. Barclays said $80 per share; Deutsche Bank predicts $95.

When profit forecasts are tightly clustered, it signals to investors that there is consensus among prognosticators; when they diverge wildly, it shows a lack of clarity. The P/E ratio tends to fall as uncertainty rises, and vice versa.

"A stock is worth its future earnings, but that involves uncertainty," said Jeremy Siegel, professor of finance at the University of Pennsylvania's Wharton School. "The more uncertainty there is, the lower the P/E will be."

Not only is the P/E ratio dropping, it also is in danger of losing some of its prominence as a market gauge.

That is because, with profit and economic forecasts becoming less reliable, investors are focusing more on global economic events as they make trading decisions, parsing everything from Japanese government-debt statistics to shipping patterns in the Baltic region.

To some extent this is in keeping with historical patterns. P/E ratios often shrink in size and significance during periods of uncertainty as investors focus on broader economic themes.

P/E ratios fell sharply during the Depression of the 1930s and again after World War II, bottoming at 5.90 in 1949. They plunged again during the 1970s, touching 6.97 in 1974 and 6.68 in 1980. During those periods, global events sometimes took precedence over company-specific valuation considerations in the minds of investors.

There have been periods when the P/E ratio was much more in vogue. A century ago, the buying and selling of stocks was widely considered to be a form of gambling. P/E ratios came about as a way to quantify the true value of a company's shares. The creation of the Securities and Exchange Commission during the 1930s made financial information more available to investors, and P/E ratios gained widespread acceptance in the decades that followed.

But thanks to the recent shift toward rapid-fire stock trading, the P/E ratio may be losing its relevance. The emergence of exchange-traded funds in the past 10 years has allowed investors to make broad bets on entire baskets of stocks. And the ascendance of computer-driven trading is making macroeconomic data and trading patterns more important drivers of market action than fundamental analysis of individual companies, even during periods of relative calm.

So where is the P/E ratio headed in the short term? A few optimists think it could rise from here. If corporate borrowing costs remain at record lows and stock prices remain depressed, companies will start issuing debt to buy back shares, said David Bianco, chief U.S. equity strategist for Bank of America Merrill Lynch. As a result, earnings per share would increase, he said, even if profit growth remains sluggish, and P/E ratios could jump with them.

But today's economic uncertainty argues against that scenario. Consider that while P/E ratios dropped during the inflationary 1970s, they also fell during the deflationary 1930s. The one common thread tying those two eras of falling P/E ratios: unpredictable economic performance.

"We're looking at a more volatile U.S. economy than we experienced in the last 30 years," said Doug Cliggott, U.S. equity strategist at Credit Suisse in Boston. "The pressure on multiples may be with us for quite some time."

September 8, 2010 reply from John Briggs, John  [briggsjw@JMU.EDU]

I saw this article and didn't quite "get" it...the title at least.

Of course the P/E ratio is still relevant.

My favorite site for this is www.multpl.com, where a guy provides a daily look at the Shiller ("Irrational Exuberance") 10-year P/E...10 years of data instead of 1.  It's currently 20.  It used to be 45.  Indeed, 45 was a bubble.

Right now, you would think 16 would be appropriate, but extremely low interest rates argue for higher (in comparison to investing in bonds), but economic uncertainly argues for lower.

So I'd make the case that this metric should be around 16 right now...20 indicates to me that stocks are slightly overvalued.

The only time the P/E ratio really was ignored was in 2000, it seems to me.  I'm glad I had no money then.

Bob Jensen's bookmarks for financial ratios --- http://faculty.trinity.edu/rjensen/Bookbob1.htm#010303FinancialRatios
Also see http://en.wikipedia.org/wiki/Financial_ratios

Bob Jensen's threads on valuation are at
http://faculty.trinity.edu/rjensen/roi.htm

Treasury Stock --- http://en.wikipedia.org/wiki/Treasury_stock

A Teaching Case About Treasury Stock

From The Wall Street Journal Accounting Weekly Review on March 2, 2012

The Pros and Cons of Stock Buybacks
by: Maxwell Murphy
Feb 27, 2012
Click here to view the full article on WSJ.com
 

TOPICS: Earnings Management, Earnings Per Share, Financial Accounting, Stock Price Effects

SUMMARY: This is the third of three articles in the WSJ's Section on Leadership in Corporate Finance published on Monday, February 27, 2012. This article is useful to introduce the economic reasoning behind treasury stock purchases prior to presenting the accounting for these transactions.

CLASSROOM APPLICATION: The article may be used in any financial accounting class covering treasury stock purchases.

QUESTIONS: 
1. (Advanced) What is a stock buyback? What term do we use in accounting for this transaction?

2. (Advanced) Summarize the accounting for stock buybacks.

3. (Introductory) What reason does Mr. Milano give for his opinion that "buybacks are...often a bad idea"?

4. (Introductory) What evidence does Mr. Milano give to support his view?

5. (Advanced) One of the reasons Mr. Tilson acknowledges that buybacks are often poorly considered by the managements who conduct them is that they focus on "propping up share price." Mr. Milano notes that stock buybacks increase earnings per share. How do stock buybacks have these effects? Do the share price effects stem from increasing earnings per share? Support your answer.

6. (Advanced) List the other two of Mr. Tilson three examples of "the wrong reasons" to conduct a stock buyback and explain how buybacks produce these two effects.
 

Reviewed By: Judy Beckman, University of Rhode Island

 

"The Pros and Cons of Stock Buybacks," by Maxwell Murphy, The Wall Street Journal, February 27, 2012 ---
http://online.wsj.com/article/SB10001424052970203824904577213891035614390.html?mod=djem_jiewr_AC_domainid

As share buybacks climb toward record, prerecession levels, the debate over the tactic is heating up.

Companies sitting on piles of cash are under increasing pressure to return that value to shareholders, but are buybacks the best way to do that? Or should companies raise dividends, use the money for acquisitions or invest it in their business instead?

We invited two Wall Street personalities with strong views on the issue to participate in an email discussion of the merits and drawbacks of stock buybacks.

Whitney R. Tilson is the founder and managing partner of T2 Partners LLC, a New York hedge fund, and an outspoken proponent of share repurchases.

Gregory V. Milano is the co-founder and chief executive of Fortuna Advisors LLC, a corporate-finance consulting firm based in New York, who rarely encounters a buyback he considers the best use of a company's cash.

Here are edited excerpts of their discussion. Crowding Out

WSJ: Mr. Milano, why you do think buybacks are so often a bad idea?

MR. MILANO: Though some are successful with share repurchases, the evidence overwhelmingly shows that heavy buyback companies usually create less value for shareholders over time.

Many managements have become so infatuated with how buybacks increase earnings per share that these distributions are crowding out sound business investments that create more value over time.

In one study, those that reinvested a higher percentage of their cash generation into capital expenditures, research and development, cash acquisitions and working capital delivered substantially higher total shareholder return than those that reinvested less.

The problem with buybacks is considerably compounded by poor timing: the propensity to buy when the price is high and not when it's low. A measure called buyback effectiveness compares the buyback return on investment to total shareholder return, and indicates whether the company buys low or high relative to the share price trend. From 2008 through mid 2011, nearly two out of three companies in the S&P 500 had negative buyback effectiveness.

Most academic research shows that share prices typically increase when buybacks are announced, which benefits short-term owners. For those interested in long-term value creation, which should be the focus of managements and boards, the evidence convincingly shows that buybacks usually do not help.

WSJ: Mr. Tilson, what makes buybacks work for investors, rather than against them?

MR. TILSON: I agree with Greg that most companies do not think or act sensibly regarding share repurchases and therefore end up destroying value.

It never ceases to amaze me—and, when a company we own does the wrong thing, infuriate me—how few companies think sensibly about this topic and thus buy back stock for all the wrong reasons: to prop up the price, signal "confidence," offset options dilution, etc.

But the same could be said of acquisitions, and does anyone believe that all acquisitions are bad? Share repurchases, like acquisitions, can create enormous long-term shareholder value if done properly.

Warren Buffett, in his 1999 letter to Berkshire Hathaway shareholders, perfectly captures the key elements of a smart share repurchase program:

"There is only one combination of facts that makes it advisable for a company to repurchase its shares: First, the company has available funds—cash plus sensible borrowing capacity—beyond the near-term needs of the business and, second, finds its stock selling in the market below its intrinsic value, conservatively calculated."

In other words, once a business has a strong balance sheet, then it should first take its excess cash/cash flow and reinvest in its own business—if (and only if) it can generate high rates of return on such investment.

Then, if it still has cash/cash flow left over, it should return it to shareholders, who are, after all, the owners of the business—it's their cash. But this raises the question of whether cash should be returned via dividends or share repurchases.

That depends on the price of the stock versus its intrinsic value.

My rule of thumb is that if the stock is trading within 20% of fair value, then the company should use dividends; if it's trading at greater than a 20% discount, buybacks. If it's trading at a big premium to fair value, then the company should issue stock, via compensation to employees, a secondary offering and/or as an acquisition currency. Getting It Wrong

MR. MILANO: I agree with the Warren Buffett quote completely, and Whitney's view on how often managements get it wrong is really one of my main principles.

As an investment banker at Credit Suisse in 2007 I visited scores of companies to explain that their share prices were so high that the expectations they needed to achieve just to justify their price, let alone grow it, were unrealistic in a world where we experience the ups and downs of business cycles. I suggested they use convertible-debt financing to fund their growth.

Continued in article

Question
There are various reasons for buying back common shares (e.g., to have shares available for employee compensation). How many of you also teach that one purpose may be to buy back your company's earnings growth?

Teaching Case
From The Wall Street Journal's Accounting Weekly Review on September 20, 2013

Microsoft Buys Back Earnings Growth
by: Rolfe Winkler
Sep 17, 2013
Click here to view the full article on WSJ.com
 

TOPICS: Dividends, Earnings Per Share, Financial Analysis

SUMMARY: The article clearly shows the impact of stock repurchases on EPS growth for large technology firms that have matured: Cisco, Microsoft, IBM, and Oracle.

CLASSROOM APPLICATION: The article may be used when covering stockholders' equity in a financial accounting class.

QUESTIONS: 
1. (Introductory) What has Microsoft announced about its stock repurchases?

2. (Introductory) Provide the journal entry to record a stock repurchase transaction.

3. (Advanced) What did Microsoft also announce at the same time as the share repurchase announcement? How do both of these actions mean that Microsoft will "keep kicking cash" to shareholders?

4. (Advanced) Explain the contents of the graphic entitled "Backstory." Specifically explain how earnings-per-share growth absent the stock buybacks is calculated.
 

Reviewed By: Judy Beckman, University of Rhode Island

 

"Microsoft Buys Back Earnings Growth," by Rolfe Winkler, The Wall Street Journal, September 17, 2013 ---
http://online.wsj.com/article/SB10001424127887323342404579081362742746426.html

It's good news for Microsoft MSFT +0.05% shareholders that the company will keep kicking back cash their way. It will also help the software giant juice earnings growth, like so many of its big tech brethren.

Microsoft's new $40 billion share-repurchase plan doesn't mark a sea change. The company is essentially replacing its last, almost-exhausted $40 billion buyback plan launched in 2008. Boosting the dividend 22%, which implies a yield of 3.4%, may have a bigger impact as it makes shares notably more attractive to income-hungry investors.

But buying back shares at such a rapid clip has led to a big decline in shares outstanding and, consequently, a sizable increase in earnings per share. In total, Microsoft has repurchased $110 billion of its own shares over its past nine fiscal years, says CapitalIQ, reducing its share count 22%. Thanks to such buybacks, the company's average annual earnings growth rate of 11% was 46% higher than it would have been holding the share count constant.

he company is hardly alone. International Business Machines IBM +0.69% has bought back $100 billion of stock over its past nine fiscal years, reducing its share count by a third and boosting its average earnings growth rate 53%, to 16%. Cisco Systems CSCO -1.26% has purchased $63 billion of stock, reducing its share count 19% and increasing average earnings growth 40%, to 10%.

Oracle ORCL -0.56% stands out not just for faster earnings growth but for far less reliance on buybacks. Earnings-per-share growth has averaged 19% a year the past nine fiscal years, just slightly higher than the 18% growth rate had its share count been unchanged. That said, even Oracle has significantly increased its share repurchases the past two years.

Higher earnings-growth rates are good news for shareholders. Still, the way tech giants manufacture that growth is a reminder that they are more about past glory than future promise.

OBSF:  Off Balance Sheet Financing

Off-Balance-Sheet Financing --- http://www.investopedia.com/terms/o/obsf.asp

A form of financing in which large capital expenditures are kept off of a company's balance sheet through various classification methods. Companies will often use off-balance-sheet financing to keep their debt to equity (D/E) and leverage ratios low, especially if the inclusion of a large expenditure would break negative debt covenants.

Contrast to loans, debt and equity, which do appear on the balance sheet. Examples of off-balance-sheet financing include joint ventures, research and development partnerships, and operating leases (rather than purchases of capital equipment).

Operating leases are one of the most common forms of off-balance-sheet financing. In these cases, the asset itself is kept on the lessor's balance sheet, and the lessee reports only the required rental expense for use of the asset. Generally Accepted Accounting Principles in the U.S. have set numerous rules for companies to follow in determining whether a lease should be capitalized (included on the balance sheet) or expensed.

This term came into popular use during the Enron bankruptcy. Many of the energy traders' problems stemmed from setting up inappropriate off-balance-sheet entities.

Bob Jensen's Document on How to Avoid Booking Leases Under FAS 13 and the New 2012 Dual Model ---
http://www.cs.trinity.edu/~rjensen/temp/LeaseAccounting.htm

Comparisons of IFRS with Domestic Standards of Many Nations
http://www.iasplus.com/country/compare.htm

More Detailed Differences (Comparisons) between FASB and IASB Accounting Standards

2011 Update

"IFRS and US GAAP: Similarities and Differences" according to PwC (2011 Edition)
http://www.pwc.com/us/en/issues/ifrs-reporting/publications/ifrs-and-us-gaap-similarities-and-differences.jhtml
Note the Download button!
Note that warnings are given throughout the document that the similarities and differences mentioned in the booklet are not comprehensive of all similarities and differences. The document is, however, a valuable addition to students of FASB versus IASB standard differences and similarities.

It's not easy keeping track of what's changing and how, but this publication can help. Changes for 2011 include:

• Revised introduction reflecting the current status, likely next steps, and what companies should be doing now
  (see page 2);
• Updated convergence timeline, including current proposed timing of exposure drafts, deliberations, comment periods, and final standards
  (see page 7);
• More current analysis of the differences between IFRS and US GAAP -- including an assessment of the impact embodied within the differences
  (starting on page 17); and
• Details incorporating authoritative standards and interpretive guidance issued through July 31, 2011
  (throughout).

This continues to be one of PwC's most-read publications, and we are confident the 2011 edition will further your understanding of these issues and potential next steps.

For further exploration of the similarities and differences between IFRS and US GAAP, please also visit our IFRS Video Learning Center.

To request a hard copy of this publication, please contact your PwC engagement team or contact us.

Jensen Comment
My favorite comparison topics (Derivatives and Hedging) begin on Page 158
The booklet does a good job listing differences but, in my opinion, overly downplays the importance of these differences. It may well be that IFRS is more restrictive in some areas and less restrictive in other areas to a fault. This is one topical area where IFRS becomes much too subjective such that comparisons of derivatives and hedging activities under IFRS can defeat the main purpose of "standards." The main purpose of an "accounting standard" is to lead to greater comparability of inter-company financial statements. Boo on IFRS in this topical area, especially when it comes to testing hedge effectiveness!

One key quotation is on Page 165

IFRS does not specifically discuss the methodology of applying a critical-terms match in the level of detail included within U.S. GAAP.
Then it goes yatta, yatta, yatta.

Jensen Comment
This is so typical of when IFRS fails to present the "same level of detail" and more importantly fails to provide "implementation guidance" comparable with the FASB's DIG implementation topics and illustrations.

I have a huge beef with the lack of illustrations in IFRS versus the many illustrations in U.S. GAAP.

I have a huge beef with the lack of illustrations in IFRS versus the many illustrations in U.S. GAAP.

I have a huge beef with the lack of illustrations in IFRS versus the many illustrations in U.S. GAAP.

Bob Jensen's threads on accounting standards setting controversies ---
http://faculty.trinity.edu/rjensen/Theory01.htm#MethodsForSetting

Comparisons of IFRS with Domestic Standards of Many Nations
http://www.iasplus.com/country/compare.htm

"Canadian regulator decides against allowing early adoption of recent IFRSs by certain entities," IAS Plus, November 1, 2011 ---
http://www.iasplus.com/index.htm

. . .

In making its decision, the OSFI considered a number of factors such as industry consistency, OSFI policy positions on accounting and capital, operational capacity and resource constraints of Federally Regulated Entities (FREs), the ability to benefit from improved standards arising from the financial crisis and the notion of a level playing field with other Canadian and international financial institutions. OSFI concluded that FREs should not early adopt the following new or amended IFRSs, but instead should adhere to their mandatory effective dates:

Continued

 

Jensen Comment
The clients, auditors, and the AICPA clamoring that U.S. firms should be able to voluntarily choose IFRS instead of U.S. GAAP even before it has not been decided that IFRS will ever replace FASB standards seem to ignore the problems that voluntary choice of IFRS might cause for investors and analysts. The above reasoning by the OSFI makes sense to me.

But then outfits like the AICPA have a self-serving interest in earning millions of dollars selling IFRS training courses and materials.
 

November 2, 2011 reply from Patricia Walters

Does that mean you oppose options to early adopt standards in general, not just IFRSs?

Pat

 

November 2, 2011 reply from Bob Jensen

Hi Pat,

It's hard to say regarding early adoption of a particular national or international standard, because there can be unique circumstances. For example, FAS 123R simply altered how to make disclosures rather than alter the disclosures themselves since employee option expenses had to be disclosed before the FAS 123R adoption date. But even here early adoption of FAS 123R by Company A versus late adoption by Company B made simple comparisons of eps and P/E ratios between these companies less easy.

There's a huge difference between early adoption of a particular standard and early adoption of an entire system of standards like switching from FASB accounting standards to IFRS.

I think the Canadian position of early adoption of IFRS is probably correct because of the mess early adoption of IFRS makes with comparisons of companies using different accounting standards and the added costs of regulation of more than one set of standards. Also think of the added burden placed upon the courts to adjudicate disputes when differing sets of standards are being used.

Even though we allow IFRS for SEC registered foreign companies, I think it would be a total mess for the SEC, the PCAOB, investors, analysts, educators, trainers, auditing, and even the IRS (where tax and reporting treatments must sometimes be reconciled) if our domestic corporations could choose between FASB versus IASB standards.

There are hundreds of differences between FASB and IASB standards. Allowing companies domestic companies to cherry pick which system they choose before it is even known if there will ever be official replacement of FASB standards by IASB standards would be very, very confusing. What if there never is a decision to replace FASB standards? Do want to simply allow companies to choose to bypass FASB standards at their own discretion?

Of course, if information were costless it might be ideal to require financial reporting where FASB and IASB outcomes are reconciled. But clients and auditors generally contend that the cost of doing this greatly exceeds benefits. And teaching financial accounting would become exceedingly complicated if we had to teach two sets of standards on an equal basis.

I would certainly hate to face a CPA examination that had nearly equal coverage of both FASB and IASB standards simultaneously. I say this especially after viewing the hundreds of pages of complicated differences between the two standards systems.

Respectfully,
Bob Jensen

Bob Jensen's threads on accounting standard setting controversies ---
http://www.trinity.edu/rjensen/Theory01.htm#MethodsForSetting

"Hidden Numbers Make Banks Even Bigger," by Floyd Norris, The New York Times, March 14, 2013 ---  Click Here
http://www.nytimes.com/2013/03/15/business/new-rules-will-give-a-truer-picture-of-banks-size.html?nl=todaysheadlines&emc=edit_th_20130315&_r=2&pagewanted=all&#h

It sounds like a simple question. How big is that bank?

But it is not.

Under American accounting rules, banks that trade a lot of derivatives can keep literally trillions of dollars in assets and liabilities off their balance sheets. Since 2009, they have at least been required to make disclosures about how large those amounts are, but the disclosures leave out some things and — amazingly enough — in some cases do not seem to add up.

The international accounting rules are different. They also allow some assets to vanish, but not nearly as many. As a result, it is virtually impossible to confidently declare how a particular European bank compares in size with an American bank.

Much of that will change when first-quarter financial statements start coming off the printing presses in a few weeks. For the first time, European and American banks are supposed to have comparable disclosures regarding assets. Their balance sheets will still be radically different, but for those who care, the comparison will be possible.

This comes to mind because these days it seems that big banks do not much want to be thought of that way. A rather angry argument has broken out regarding whether “too big to fail” institutions get what amounts to a subsidy from investor confidence that no matter what else happens, they would not be allowed to fail. The banks deny it all. Subsidy? Penalty is more like it, they say.

We’ll get back to that argument in a moment. But first, there is some evidence that the big American banks may have scaled back their derivatives positions last year. At five of six major financial institutions, the amount of assets kept off the balance sheet appears to be lower at the end of 2012 than it was a year earlier.

Still, the numbers are big. JPMorgan Chase, the biggest American institution, had $2.4 trillion in assets on its balance sheet at the end of 2012. But it has derivatives with a market value of an additional $1.5 trillion that it does not show on its balance sheet, down from $1.7 trillion a year earlier.

So is JPMorgan getting bigger? Measured by assets on the balance sheet, the answer is yes. That total was up $93 billion from 2011. But after adjusting for the hidden assets, the bank appears to have shrunk by $109 billion last year. If the bank used international accounting rules, it appears it would be getting smaller.

Not having those assets on the balance sheet makes the bank look less leveraged than it might otherwise appear to be. If you simply compare the book value of the bank with its assets, it appears it has $11.56 in assets for every dollar in equity. Add in those derivatives, and the figure leaps to $18.95.

It is not as if those assets are not real, or that they are perfectly offset by liabilities also kept off the balance sheet. There is a similar amount of liabilities that are not shown, but there is no way to know just how they match up with the assets in terms of riskiness. The nature of derivatives makes it hard to assess aggregate totals.

If a bank has a $1 million loan to someone, that is an asset that would go on the balance sheet at $1 million. Presumably the worst that could happen is that the bank would lose the entire amount. But a large derivative position might currently have a market value of $1 million, and thus would be shown as being worth the same amount, whether on or off the balance sheet. But if the market moves sharply, the profit or loss could be many multiples of that figure.

Under American accounting rules, banks that deal in derivatives can net out most of their exposure by offsetting the assets against the liabilities. They do this based not on the nature of the asset or liability, but on the identity of the institution on the other side of the trade — the counterparty, in market lingo.

The logic of this has to do with what would happen in a bankruptcy. What are called “netting agreements” allow only the net value to be claimed in case of a failure. So the bank shows the sum of those net positions with each party.

But those positions are not offsetting in terms of risk, or at least there is no way to know if they are. The figures shown in the financial statements and footnotes simply describe market values on the day of the balance sheet. If prices move the wrong way, as asset can turn into a liability, or a liability can become much larger. And both can happen at the same time. The asset might be an interest rate swap, while the liability is a wheat future. Obviously, they are not particularly likely to move in tandem.

To return to JPMorgan, on its balance sheet are derivative assets of $75 billion, and derivative liabilities of $71 billion. Neither number is very large relative to the size of the bank, and you might think that swings in values would be unlikely to be very large.

But those numbers are $1.5 trillion smaller than the actual totals. Obviously, the swings on a portfolio of that size could be much larger.

A few years ago, the accounting rule makers set out to get rid of the netting, and make balance sheets more accurate. But there were complaints from banks and others, and the American rule makers at the Financial Accounting Standards Board concluded that was not a good idea. So there is still netting in the United States. Some of it, involving repos and reverse repos, is not disclosed at all now, but will be when the new rules kick in.

The sort-of invisible derivative assets and liabilities are only part of the reason that it is so hard to really get a handle on just how risky any given bank is.

Continued in article

I never could understand the reasons for this amendment to FAS 133 that originally did not allow such offsetting. At the time I blamed it on the zeal for convergence with the IASB and political pressures that seemed to be even greater in Europe than the U.S. Perhaps I was wrong in this.

I'm beginning to think that when something smells fishy there probably are some rancid fish hiding somewhere

I've never been in favor of what I think is one of the worst decisions ever made by the FASB that runs counter to the original FAS 133 requirements.
"Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities," ASU No. 2011-08, FASB --- Click Here
http://www.fasb.org/cs/BlobServer?blobkey=id&blobwhere=1175825893217&blobheader=application%2Fpdf&blobcol=urldata&blobtable=MungoBlobs

Why Is the FASB Issuing
This Accounting Standards Update (Update) ? The main objective in developing this Update is to address implementation issues about the scope of Accounting Standards Update No. 2011 - 11, Balance Sheet (Topic 210) : Disclosures about Offsetting Assets and Liabilities . Stakeholders have told the Board that because the scope in Update 2011 - 11 is unclear, diversity in practice may result . Recent feedback from stakeholders is that standard commercial provisions of many contracts would equate to a master netting arrangement . Stakeholders questioned whether it was the Board’s intent to require disclosures for such a broad scope, which would significantly increase the cost of compliance . The objective of this Update is to clarify the scope of the offsetting disclosures and address any unintended consequences.

What Are the Main Provisions?
The amendments clarify that the scope of Update 2011 - 11 applies to derivatives accounted for in accordance with Topic 815, Derivatives and Hedging, including bifurcated embedded derivatives , repurchase agreements and reverse repurchase agreements, and securities borrowing and securities lending transactions that are either offset in accordance with Section 210 - 20 - 45 or Section 815 - 10 - 45 or subject to an enforceable master netting arrangement or similar agreement .

Who Is Affected by the Amendments in This Update?
The amendments in this Update affect entities that have derivatives accounted for in accordance with Topic 815, including bifurcated embedded derivatives , repurchase agreements and reverse repurchase agreements, and securities borrowing and securities lending transactions that are either offset in accordance with Section 210 - 20 - 45 or Section 815 - 10 - 45 or subject to an enforceable master netting arrangement or similar agreement . Entities with other types of financial a ssets and financial liabilities subject to a master netting arrangement or similar agreement also are affected because these amendments make them no longer subject to the disclosure requirements in Update 2011 - 11.

How Do the Main Provisions?
Differ from Cur rent U.S. Generally Accepted Accounting Principles ( GAAP ) and Why Would They Be an Improvement? The amendments clarify the intended scope of the disclosures required by Section 210 - 20 - 50 . The Board concluded that the clarified scope will reduce significant ly the operability concerns expressed by preparers while still providing decision - useful information about certain transactions involving master netting arrangements . The amendments provide a user of financial statements with comparable information as it r elates to certain reconciling differences between financial statements prepared in accordance with U.S. GAAP and those financial statements prepared in accordance with International Financial Reporting Standards (IFRS).

When W ill the Amendments Be Effective?
An entity is required to apply the amendments for fiscal years beginning on or after January 1, 2013, and interim periods within those annual periods . An entity should provide the required disclosures retrospectively for all comparative periods presented . The effective date is the same as the effective date of Update 2011 - 11.

How Do the Provisions Compare with International Financial Reporting Standards (IFRS)?
The disclosures required by the amendments in Update 2011 - 11 are the result of a joint project between the FASB and the International Accounting Standards Board (IASB), which was intended to provide comparable information about balance sheet offsetting between those entities that prepare their financial statements on the basis of U.S. GAAP and those entities that prepare their financial statements on the basis of IFRS . The amendments in this Update clarify that the scope of the disclosures under U.S. GAAP is limited to include derivatives accounted for in accordance with Topic 815 , including bifurcated embedded derivatives, repurchase agreements and reverse repurchase agreements, and securities borrowing and securities lending transactions that are either offset in accordance with Section 210 - 20 - 45 or Section 815 - 10 - 45 or subject to a n enforceable master netting arrangement or similar agreement.

Continued in article

I personally was more concerned about how banks changed income smoothing practices.
"The Impact of SFAS 133 on Income Smoothing by Banks through Loan Loss Provisions," by Emre Kilic Gerald J. Lobo, Tharindra Ranasinghe, and K. Sivaramakrishnan Rice University, The Accounting Review, Vol. 88, No. 1, 2013, pp. 233-260 ---
http://aaajournals.org/doi/pdf/10.2308/accr-50264

We examine the impact of SFAS 133, Accounting for Derivative Instruments and Hedging Activities , on the reporting behavior of commercial banks and the informativeness of their financial statements. We argue that, because mandatory recognition of hedge ineffectiveness under SFAS 133 reduced banks’ ability to smooth income through derivatives, banks that are more affected by SFAS 133 rely more on loan loss provisions to smooth income. We find evidence consistent with this argument. We also find that the increased reliance on loan loss provisions for smoothing income has impaired the informativeness of loan loss provisions for future loan defaults and bank stock returns.

Executory Contracts: The Root of Most Off-Balance-Sheet-Financing Evils

Here's another Onion post from Tom.

In FAS 133 there's a big deal distinction between forecasted transactions (no signed executory contracts) versus firm commitments (signed executory contracts). Both types of "commitments" are are frequently hedged such that the "big deal" is not so much whether a contract has been signed as it is the type of hedge accounting that's called for such as a cash flow hedge versus a fair value hedge versus a FX hedge.

Since we're virtually certain that Southwest Airlines is going to need to purchase jet fuel over the next five years, it hardly matters much in theory whether there is an unsigned  forecasted transaction or a signed executory contract other than if one of the counterparties breaches the contract the signed contract may lead to some damage settlement.

When you drill down to the issue of whether an executory contract should be booked as a liability, one issue is the estimation of damages if the contract is breached. One reason we do not book long-term purchase contracts is that the damages from breach of contract are often a miniscule portion of the notionals times the underlyings.

My favorite example is a contract many years back signed by Dow Jones to buy newsprint (reels of paper) from St. Regis Paper Company for something like 50 years worth of paper upon which such things as The Wall Street Journal would be printed. Some of the trees needed for that paper had not even been planted yet in the timberlands when the contract was signed.

The present value of executory contract is massive in terms of discounted cash flow liability for the entire purchase. But if one of the counterparties to the contract breaks the contract the estimated damages most likely are only be a miniscule portion of the "gross" present value of the liability.

Hence booking such long-term purchase contracts at "gross" present values can be more misleading than not booking them at all. And estimation of the "damages" at any point in time is extremely difficult and probably should not be attested to by auditors.

With that introduction I will turn the floor over to Tom. I don't think the issue has so much to do with "politics" as it has to do with economic realism in many instances.

By the way, I've been told by several business law professors that the term "executory contract" is probably overused by accountants since the "executory" adjective is not considered such an important term in law schools. However, I've never really looked into this matter.

"Executory Contracts: The Root of Most Off-Balance-Sheet-Financing Evils," by Tom Selling, The Accounting Onion, January 23, 2011 --- Click Here
http://accountingonion.typepad.com/theaccountingonion/2011/01/executory-contracts-the-root-of-most-off-balance-sheet-financing-evils.html?utm_source=feedburner&utm_medium=email&utm_campaign=Feed%3A+typepad%2Ftheaccountingonion+%28The+Accounting+Onion%29

Bob Jensen's threads on OBSF ---
http://faculty.trinity.edu/rjensen/Theory02.htm#OBSF2

October 7, 2010 IFRS Update on OBSF and Repo Sales Ploys to Hide Debt
"Accounting rules get tough on ‘window dressing’," by Jennifer Hughes, Financial Times, October 7, 2010 ---
http://www.ft.com/cms/s/0/0e8f2954-d236-11df-8fbe-00144feabdc0.html 

Banks will have to disclose in detail ‘window dressing’ tricks such as Lehman Brothers’ infamous “Repo 105” deals under new international accounting rules.

The International Accounting Standards Board on Thursday published final rules that also require greater disclosure of off-balance sheet entities where the bank or company still has some ties, such as the buyer having a right to sell them back, or the bank itself having a right to repurchase the assets.

Window dressing became a contentious issue this year when it emerged that Lehman Brothers had shifted up to $49bn off its books at the end of each quarter to reduce closely watched financial leverage ratios. The trades were specifically designed to flatter the reported accounts and had no economic rationale.

The bank used short-term repurchase, or “repo”, deals and provided extra collateral – at least 105 per cent of the value of the loan – to allow it to account for the deal, under US rules, as a true sale, which removed the asset from its books until the trade was unwound after the reporting period had ended.

While international rules would not have allowed Repo 105s to be taken off the books (because they are based on a different concept to the US standards), the new rules will force banks to disclose any “disproportionate amount of transfer transactions”, such as other repo deals, that are undertaken around the end of a reporting period.

More than 100 countries follow, or are adopting, international accounting standards, including all European Union members, Japan, Canada, Australia and South Korea.

Sir David Tweedie, chairman of the IASB, said the new rules were important.

“They will help investors to better understand off-balance sheet risks, and to alert them to the possibility of so-called window dressing transactions occurring at the end of a reporting period,” he added.

Last month, the US Securities and Exchange Commission attacked the use of repo trades for window dressing, proposing that companies must disclose average and maximum short-term borrowings and explain any significant discrepancy between the two.

It also backed immediate guidance to make clear that regardless of the letter of the rules, it did not consider any company was allowed to use deals, such as Repo 105s, that were designed to mask its reported financial condition.

Although the IASB has stopped short of requiring banks to produce the disclosures in a specified format, it will require them to be in one place, rather than scatter through the accounts. It has also suggested various formats. This is still a step-up in the prescriptiveness of its standards, which it had been trying to base around broad principles to avoid it having to follow the US where rulemakers tend to draft detailed rules to cover each separate situation.

"Balance Sheets Are Busting Out All Over:  About $1.2 trillion in off-balance-sheet assets could end up on the balance sheets of banks that have yet to claim them, or "on no one's balance sheet," a new report claims," by Marie Leone, CFO.com, April 23, 2010 ---
http://www.cfo.com/article.cfm/14492562/c_14492952?f=home_todayinfinance

New accounting rules governing off-balance-sheet transactions went into effect for most companies in January. As a result, 53 large companies have already estimated that they will have put back an aggregate $515 billion in assets to their balance sheets during the first quarter, according to a new study of S&P 500 companies released by Credit Suisse.

But the future state of the companies' balance sheets remains unclear, since they only consolidated 9% of the $5.7 trillion in off-balance sheet assets they reported in the fourth quarter of last year. About $4 trillion of the remaining assets will be taken up on the balance sheets of mortgage companies Fannie Mae and Freddie Mac, which guaranteed many of the subprime residential mortgages. The rest of the assets — about $1.2 trillion worth — could find their way to the balance sheets of companies that have yet to claim them, or "on no one's balance sheet," assert report authors David Zion, Amit Varshney, and Christopher Cornett.

Because some assets are lingering in accounting limbo or hidden by murky disclosures, gauging their final effect on company financials could be akin to hitting "a moving target," says the report. Indeed, Credit Suisse notes that it's unclear whether all reported estimates issued during the first quarter included deferred taxes, loan loss provisioning, and such off-balance-sheets assets as mortgage-servicing rights. (Selling mortgage servicing rights is a multi-billion dollar industry.)

The rules that force companies to put such assets back on their balance sheets were issued in 2008 and went into effect at the beginning of this year. They are Topic 860 (formerly FAS 166), which deals with transfers and servicing of financial assets and liabilities, and Topic 810 (formerly FAS 167), the rule governing the consolidation of off-balance-sheet entities in their controlling companies' financial reports.

In reviewing the results and disclosures as of March 11, the study's authors found that only 183 companies in the S&P 500 reported the balance-sheet effects of FAS 166 in their financial results, with 24 providing an estimated impact and 117 reporting either no impact or an immaterial one. Forty-two companies are still evaluating the effects of the new rules, while 317 made no mention of the rules at all. In contrast, 342 companies disclosed the effects of FAS 167, with 29 providing estimates and 214 registering no impact or an immaterial one. That leaves 99 companies still evaluating the FAS 167 impact, and 158 making no mention of the financial statement effects.

Predictably, most of the asset increases belong to companies in the financial sector, where off-balance-sheet transactions like securitization, factoring, and repurchase agreements are popular. As of Q4 2009, financial services companies in the S&P 500 had stashed $5.5 trillion, and $1.6 trillion, respectively, in variable-interest entities (VIEs) and the now-defunct qualified special-purporse entities (QSPEs). That left a mere $110 billion in assets spread among the QSPEs and VIEs associated with companies in nine other industries.

Assets are returning to balance sheets for several reasons, most notably the Financial Accounting Standards Board's elimination if QSPEs, or "Qs," in 2008, when it became apparent that the structures were being abused. Indeed, Qs were permitted to remain off bank balance sheets if they took a "passive" role in managing the structures' finances. But when the subprime crisis hit, and the mortgages being held in Qs began to fail, banks — with the blessing of regulators — took a more active role, reworking the terms of the entities' mortgage investments. At the time, FASB Chairman Robert Herz called Qs "ticking time bombs" that started to "explode" during the credit crunch.

VIEs, on the other hand, are still used. These vehicles are thinly capitalized business structures in which investors can hold controlling interests without having to hold voting majorities. As of the fourth quarter last year, S&P 500 companies parked $1.7 trillion worth of assets in VIEs.

The revised standards were supposed to wreak havoc on bank balance sheets because, among other things, the rules for keeping loan-related assets off the books would be rewritten. At the time, bankers expected the rewrite would force them to consolidate big swaths of assets that were being held in VIEs and QSPEs. And consolidating the assets from the entities would have required them to increase the amount of regulatory capital they kept on hand — a charge to cash — and thereby reduce the amount of lending they could do. Dampening lending during a credit crisis, argued bankers, would hurt the recovery.

Since their enactment, the accounting rules have affected their industry big-time. Of the companies reporting an impact, nine purely financial-sector outfits plus General Electric account for 96% of the $515 billion being consolidated during the first quarter, says Credit Suisse. Of that group, which includes Bank of America, JP Morgan Chase, and Capital One, Citigroup tops the list with an estimated $129 billion in assets being brought back on the books in the first quarter — which represents 7% of its existing total assets. The newly-consolidated assets come in all shapes and sizes, says the report: $86.3 billion in credit card loans, $28.3 billion in asset-backed commercial paper, $13.6 billion in student loans, and $4.4 billion in consumer mortgages, for example. ($5 trillion or the $ $5.7 trillion held in VIEs and QSPEs are mortgage related.) Citigroup also disclosed a $13.4 billion charge for setting up additional loan loss reserves and eliminating interest lost from consolidating the assets.

Of the companies that disclosed the financial-statement impact, only eight estimated the increase to be more than 5% of total assets, says Credit Suisse. Invesco was the hardest hit, reporting the highest percentage at 55%, bringing back $6 billion worth of assets during the first quarter. Invesco's assets are parked in collateralized loan obligations and collateralized debt obligations.

Non-financial companies, like Harley-Davidson and Marriott International also reported relatively big percentage jumps compared to existing assets. Harley's additional assets represent 18% of existing assets, or $1.6 billion. Meanwhile, Marriott's consolidation represents 13% of its assets, or $1 billion.

Jensen Comment
It's about time. Bank financial statements have been "fiction" for way to long.
But the accounting and auditing rules have a long way to go for banks. A huge problem is the way auditing firms have allowed banks to underestimate loan loss reserves. A more recent problem with FAS 140 was uncovered by Lehman's use of Repo 105 contracts for debt masking.

After the Bailout the Banks are Still Hiding Debt and the Auditors Acquiesce
"Major Banks Said to Cover Up Debt Levels," The New York Times via The Wall Street Journal, April 9, 2010 ---
http://dealbook.blogs.nytimes.com/2010/04/09/major-banks-said-to-cover-debt-levels/?dlbk&emc=dlbk

Goldman Sachs, Morgan Stanley, JPMorgan Chase, Bank of America and Citigroup are the big names among 18 banks revealed by data from the Federal Reserve Bank of New York to be hiding their risk levels in the past five quarters by lowering the amount of leverage on the balance sheet before making it available to the public, The Wall Street Journal reported.

The Federal Reserve’s data shows that, in the middle of successive quarters, when debt levels are not in the public domain, that banks would acknowledge debt levels higher by an average of 42 percent, The Journal says.

“You want your leverage to look better at quarter-end than it actually was during the quarter, to suggest that you’re taking less risk,” William Tanona, a former Goldman analyst and head of financial research in the United States at Collins Stewart, told The Journal.

The newspaper suggests this practice is a symptom of the 2008 crisis in which banks were harmed by their high levels of debt and risk. The worry is that a bank displaying too much risk might see its stocks and credit ratings suffer.

There is nothing illegal about the practice, though it means that much of the time investors can have little idea of the risks the any bank is really taking.

 

Lehman/Ernst Teaching Case on the Largest Bankruptcy in History
From The Wall Street Journal Accounting Weekly Review on March 19, 2010

Examiner: Lehman Torpedoed Lehman
by: Mike Spector, Susanne Craig, Peter Lattman
Mar 11, 2010
Click here to view the full article on WSJ.com

TOPICS: Advanced Financial Accounting, Debt, Degree of Operating Leverage, Disclosure, Revenue Recognition

SUMMARY: "A federal judge released a scathing report on the collapse of Lehman Brothers Holdings Inc. that singles out senior executives, auditor Ernst & Young and other investment banks for serious lapses that led to the largest bankruptcy in U.S. history...." The report focuses on the use of "repos" to improve the appearance of Lehman's financial condition as it worsened with the market declines beginning in 2007. "Mr Valukus, chairman of law firm Jenner & Block, devotes more than 300 pages alone to balance sheet manipulation..." through repo transactions. As explained more fully in the related articles, repurchase agreements are transactions in which assets are sold under the agreement that they will be repurchased within days. Yet, when Lehman exchanged assets with a value greater than 105% of the cash received for them, the company would report it as an outright sale of the asset, not a loan, thus reducing the firms apparent leverage. These transactions were based on a legal opinion of the propriety of this treatment made for their European operations, but the company never received such an opinion letter in the U.S., so Lehman transferred assets to Europe in order to execute the trades. The second related article clarifies these issues. Of course, this was but one significant problem; other forces helped to "tip Leham over the brink" into bankruptcy including J.P. Morgan Chases' "demands for collateral and modifications to agreements...that hurt Lehman's liquidity...."

CLASSROOM APPLICATION: The questions ask students to understand repurchase agreements and cases in which financing (borrowing) transactions might alternatively be treated as sales. The role of the auditor, in this case Ernst & Young, also is highlighted in the article and in the questions in this review.

QUESTIONS: 
1. (Introductory) What report was issued in March 2010 regarding Lehman Brothers? Summarize some main points about the report.

2. (Advanced) Based on the discussion in the main and first related articles, describe the "repo market'. What is the business purpose of these transactions?

3. (Advanced) How did Lehman Brothers use repo transactions to improve its balance sheet? Note: be sure to refer to the related articles as some points in the main article emphasize the impact of removing the assets that are subject to the repo agreements from the balance sheet. The main point of your discussion should focus on what else might have been credited in the entries to record these transactions.

4. (Introductory) Refer to the second related article. What was the role of Lehman's auditor in assessing the repo transactions? What questions have been asked of this firm and how has E&Y responded?

Reviewed By: Judy Beckman, University of Rhode Island

RELATED ARTICLES: 
Lehman Maneuver Raises Accounting Question.
by David Reilly
Mar 13, 2010
Online Exclusive

 

"Examiner: Lehman Torpedoed Lehman," by: Mike Spector, Susanne Craig, Peter Lattman, The Wall Street Journal, Mar 11, 2010 ---
http://online.wsj.com/article/SB10001424052748703625304575115963009594440.html?mod=djem_jiewr_AC_domainid

A scathing report by a U.S. bankruptcy-court examiner investigating the collapse of Lehman Brothers Holdings Inc. blames senior executives and auditor Ernst & Young for serious lapses that led to the largest bankruptcy in U.S. history and the worst financial crisis since the Great Depression.

In the works for more than a year, and costing more than $30 million, the report by court-appointed examiner Anton Valukas paints the most complete picture yet of the free-wheeling culture inside the 158 year-old firm, whose chief executive Richard S. Fuld Jr. prided himself on his ability to manage market risk.

The document runs thousands of pages and contains fresh allegations. In particular, it alleges that Lehman executives manipulated its balance sheet, withheld information from the board, and inflated the value of toxic real estate assets.

Lehman chose to "disregard or overrule the firm's risk controls on a regular basis,'' even as the credit and real-estate markets were showing signs of strain, the report said.

In one instance from May 2008, a Lehman senior vice president alerted management to potential accounting irregularities, a warning the report says was ignored by Lehman auditors Ernst & Young and never raised with the firm's board.

The allegations of accounting manipulation and risk-control abuses potentially could influence pending criminal and civil investigations into Lehman and its executives. The Manhattan and Brooklyn U.S. attorney's offices are investigating, among other things, whether former Lehman executives misled investors about the firm's financial picture before it filed for bankruptcy protection, and whether Lehman improperly valued its real-estate assets, people familiar with the matter have said.

The examiner said in the report that throughout the investigation it conducted regular weekly calls with the Securities and Exchange Commission and Department of Justice. There have been no prosecutions of Lehman executives to date.

Several factors helped to tip Lehman over the brink in its final days, Mr. Valukas wrote. Investment banks, including J.P. Morgan Chase & Co., made demands for collateral and modified agreements with Lehman that hurt Lehman's liquidity and pushed it into bankruptcy.

Lehman's own global financial controller, Martin Kelly, told the examiner that "the only purpose or motive for the transactions was reduction in balance sheet" and "there was no substance to the transactions." Mr. Kelly said he warned former Lehman finance chiefs Erin Callan and Ian Lowitt about the maneuver, saying the transactions posed "reputational risk" to Lehman if their use became publicly known.

In an interview with the examiner, senior Lehman Chief Operating Officer Bart McDade said he had detailed discussions with Mr. Fuld about the transactions and that Mr. Fuld knew about the accounting treatment.

In an April 2008 email, Mr. McDade called such accounting maneuvers "another drug we r on." Mr. McDade, then Lehman's equities chief, says he sought to limit such maneuvers, according to the report. Mr. McDade couldn't be reached to comment.

In a November 2009 interview with the examiner, Mr. Fuld said he had no recollection of Lehman's use of Repo 105 transactions but that if he had known about them he would have been concerned, according to the report.

Mr. Valukas's report is among the largest undertaking of its kind. Those singled out in the report won't face immediate repercussions. Rather, the report provides a type of road map for Lehman's bankruptcy estate, creditors and other authorities to pursue possible actions against former Lehman executives, the bank's auditors and others involved in the financial titan's collapse.

One party singled out in the report is Lehman's audit firm, Ernst & Young, which allegedly didn't raise concerns with Lehman's board about the frequent use of the repo transactions. E&Y met with Lehman's Board Audit Committee on June 13, one day after Lehman senior vice president Matthew Lee raised questions about the frequent use of the transactions.

"Ernst & Young took no steps to question or challenge the nondisclosure by Lehman of its use of $50 billion of temporary, off-balance sheet transactions," Mr. Valukas wrote.

In a statement, Mr. Fuld's lawyer, Patricia Hynes, said, "Mr. Fuld did not know what those transactions were—he didn't structure or negotiate them, nor was he aware of their accounting treatment."

An Ernst & Young statement Thursday said Lehman's collapse was caused by "a series of unprecedented adverse events in the financial markets." It said Lehman's leverage ratios "were the responsibility of management, not the auditor."

Ms. Callan didn't respond to a request for comment. An attorney for Mr. Lowitt said any suggestion he breached his duties was "baseless." Mr. Kelly couldn't be reached Thursday evening.

As Lehman began to unravel in mid-2008, investors began to focus their attention on the billions of dollars in commercial real estate and private-equity loans on Lehman's books.

The report said that while Lehman was required to report its inventory "at fair value," a price it would receive if the asset were hypothetically sold, Lehman "progressively relied on its judgment to determine the fair value of such assets."

Between December 2006 and December 2007, Lehman tripled its firmwide risk appetite.

But its risk exposure was even larger, according to the report, considering that Lehman omitted "some of its largest risks from its risk usage calculations" including the $2.3 billion bridge equity loan it provided for Tishman Speyer's $22.2 billion take over of apartment company Archstone Smith Trust. The late 2007 deal, which occurred as the commercial-property market was cresting, led to big losses for Lehman.

Lehman eventually added the Archstone loan to its risk usage profile. But rather than reducing its balance sheet to compensate for the additional risk, it simply raised its risk limit again, the report said.

Where Were the Auditors? ---
http://faculty.trinity.edu/rjensen/2008Bailout.htm#AuditFirms

Bob Jensen's threads on off-balance-sheet financing (OBSF) ---
http://faculty.trinity.edu/rjensen/theory01.htm#OBSF2

A Teaching Case on How Regulators Are Targeting Financial Statement "Window Dressing"

From The Wall Street Accounting Weekly Review on September 24, 2010

Regulators to Target 'Window Dressing'
by: Michael Rapoport
Sep 16, 2010
Click here to view the full article on WSJ.com

TOPICS: Banking, Debt, Disclosure, Disclosure Requirements, SEC, Securities and Exchange Commission

SUMMARY: Federal regulators are poised to propose new disclosure rules targeting "window dressing...." The SEC "...is expected to issue proposal for public comment. The action follows a Wall Street Journal investigation...of financial data fro 18 large banks...[which] showed that, as a group, they have consistently lowered debt at the end of each of the past six quarters, reducing it on average by 42% from quarterly peaks."

CLASSROOM APPLICATION: The article can be used to discuss window dressing beyond the banking sector, to discuss current reactions to the financial crisis, and to discuss leverage and debt levels.

QUESTIONS: 
1. (Advanced) Define window dressing, going beyond what is offered in this article. Is this issue found in other industries beyond banking?

2. (Advanced) What has been the nature of the window dressing issue in the banking industry? Include in your answer an explanation of the chart "Masking Risk" associated with the article.

3. (Introductory) According to the article, what prompted banks to undertake these window dressing activities?

4. (Introductory) How have banks reacted to this WSJ report on window dressing?

5. (Introductory) What is the SEC proposing to do to improve financial reporting in order to address this issue?

6. (Advanced) Do you think the SEC's plan is adequate to address this issue? In your answer, comment on the nature of items included on the face of the balance sheet versus those disclosed in the financial statement footnotes.

7. (Advanced) Describe a transaction that will help "window dress" financial statements for quarter end or year end reporting.

Reviewed By: Judy Beckman, University of Rhode Island

"Regulators to Target 'Window Dressing'," by: Michael Rapoport. The Wall Street Journal, September 16, 2010 ---
http://online.wsj.com/article/SB10001424052748703743504575494144270313302.html?mod=djem_jiewr_AC_domainid

Federal regulators are poised to propose new disclosure rules targeting "window dressing," a practice undertaken by some large banks to temporarily lower their debt levels before reporting finances to the public.

The Securities and Exchange Commission is scheduled to take up the matter at a meeting Friday and is expected to issue proposals for public comment. The action follows a Wall Street Journal investigation into the practice, which isn't illegal but masks banks' true levels of borrowing and risk-taking.

A Journal analysis of financial data from 18 large banks known as primary dealers showed that as a group, they have consistently lowered debt at the end of each of the past six quarters, reducing it on average by 42% from quarterly peaks.

The practice suggests the banks are carrying more risk than is apparent to their investors or customers, who only see the levels recorded on the companies' quarterly balance sheets.

The SEC focus comes two years after the peak of the financial panic, which was exacerbated by high levels of borrowing by the nation's banks.

Since then, heightened scrutiny from regulators and investors has prompted banks to be more sensitive about showing high debt levels.

The SEC is expected to propose rules requiring greater disclosure from banks and other companies about their short-term borrowings.

The agency's staff has been considering whether banks should be required to provide more frequent disclosure of their average borrowings, which would give a better picture of their debt throughout a quarterly period than do period-end figures.

An SEC spokesman declined to comment.

Short-term borrowing pumps up risk-taking by banks, allowing them to make bigger trading bets.

Currently, banks are required to disclose their average borrowings only annually, and nonfinancial companies aren't required to disclose their average borrowings at all.

Last month, Sen. Robert Menendez, a New Jersey Democrat, and five other senators urged the agency to require more disclosure so the public could see if a company tried to dress up its quarterly borrowings.

"Rather than relying on carefully staged quarterly and annual snapshots, investors and creditors should have access to a complete real-life picture of a company's financial situation," the senators wrote to SEC Chairman Mary Schapiro, citing the Journal articles, among other things.

Ms. Schapiro, through a spokesman, declined to comment. Mr. Menendez's office didn't return a call.

Some large banks, including Bank of America Corp. and Citigroup Inc., frequently have lowered their levels of repurchase agreements, a key type of short-term borrowing, at the ends of fiscal quarters, then boosted those "repo" levels again after the next quarter began.

The banks have said they are doing nothing wrong, and that the fluctuations in their balance sheets reflect the needs of their clients and market conditions.

But the practices suggest the banks are more leveraged and carry more risk during periods when that information isn't disclosed to the public.

At Friday's meeting, the SEC also will consider additional guidance for companies about what they should disclose about borrowing practices in the "Management's Discussion and Analysis" sections of their securities filings.

In the wake of the financial crisis, the SEC's staff has been taking a fresh look at companies' disclosures in these "MD&A" sections about liquidity and capital resources.

In the SEC staff's view, balance-sheet fluctuations can happen for legitimate reasons, and the important thing is disclosing them to investors when they are material.

Concern about hidden risk-taking by banks was heightened after a March report about the collapse of Lehman Brothers Holdings Inc.

A bankruptcy-court examiner said Lehman had used a repo-accounting strategy dubbed "Repo 105" to take $50 billion in assets off its balance sheet and make its finances look healthier than they were.

The SEC later asked major banks for data about their repo accounting. SEC Chief Accountant James Kroeker said in May that the commission's effort hadn't uncovered widespread inappropriate practices.

Still, both Bank of America and Citigroup found errors in their repo accounting that amounted to billions of dollars, though these were relatively small in the context of their giant balance sheets.

An investigation by the SEC's enforcement division into Lehman's collapse is zeroing in on this Repo 105 accounting maneuver, according to people familiar with the situation.

In an April congressional hearing, Rep. Gregory W. Meeks, a New York Democrat, asked Ms. Schapiro about the Journal's findings regarding banks' end-of-quarter debt reductions.

"It appears investment banks are temporarily lowering risk when they have to report results, [then] they're leveraging up with additional risk right after," Mr. Meeks said. "So my question is: Is that still being tolerated today by regulators, especially in light of what took place with reference to Lehman?"

Ms. Schapiro said the commission is gathering detailed information from large banks, "so that we don't just have them dress up the balance sheet for quarter end and then have dramatic increases during the course of the quarter."

Bob Jensen's threads on accounting theory ---
http://faculty.trinity.edu/rjensen/theory01.htm

Lehman/Ernst Teaching Case on the Largest Bankruptcy in History
March 18, 2010 reply from Bob Jensen

Dear Jim,

The Repo 105 issue was more like having a poisoned CDO bond worth $1 that you sell for $1,000 with a guaranteed buyback in a week for $1,005. That way you report a sale for $1,000, an asset of $0 in the balance sheet for a “sold investment,” and $0 for the liability to buy it back. Sounds like a bad economic deal and a great OBSF ploy. Of course it’s not necessarily boosting earnings if you paid more than $1,000 for the CDO cookie crumbles in the first place in the first place.

But it sure beats writing investments down from $1,000 to a $1.

Ernst and Young claims using these contracts to keep billions of dollars of poison investments and unbooked debt out of the financial statements result fairly present the financial status of sales and liabilities in the financial statements.

Do our Accounting 101 and Auditing 101 students concur?
God help this profession if our students side with Ernst & Young!

Frank Partnoy and Lynn Turner contend that Wall Street bank accounting is an exercise in writing fiction:
Watch the video! (a bit slow loading)
Lynn Turner is Partnoy's co-author of the white paper."Make Markets Be Markets"
"Bring Transparency to Off-Balance Sheet Accounting," by Frank Partnoy, Roosevelt Institute, March 2010 ---
http://www.rooseveltinstitute.org/policy-and-ideas/ideas-database/bring-transparency-balance-sheet-accounting
Watch the video!

Bob Jensen

Lehman/Ernst Teaching Case on the Largest Bankruptcy in History
From The Wall Street Journal Accounting Weekly Review on March 19, 2010

Examiner: Lehman Torpedoed Lehman
by: Mike Spector, Susanne Craig, Peter Lattman
Mar 11, 2010
Click here to view the full article on WSJ.com

TOPICS: Advanced Financial Accounting, Debt, Degree of Operating Leverage, Disclosure, Revenue Recognition

SUMMARY: "A federal judge released a scathing report on the collapse of Lehman Brothers Holdings Inc. that singles out senior executives, auditor Ernst & Young and other investment banks for serious lapses that led to the largest bankruptcy in U.S. history...." The report focuses on the use of "repos" to improve the appearance of Lehman's financial condition as it worsened with the market declines beginning in 2007. "Mr Valukus, chairman of law firm Jenner & Block, devotes more than 300 pages alone to balance sheet manipulation..." through repo transactions. As explained more fully in the related articles, repurchase agreements are transactions in which assets are sold under the agreement that they will be repurchased within days. Yet, when Lehman exchanged assets with a value greater than 105% of the cash received for them, the company would report it as an outright sale of the asset, not a loan, thus reducing the firms apparent leverage. These transactions were based on a legal opinion of the propriety of this treatment made for their European operations, but the company never received such an opinion letter in the U.S., so Lehman transferred assets to Europe in order to execute the trades. The second related article clarifies these issues. Of course, this was but one significant problem; other forces helped to "tip Leham over the brink" into bankruptcy including J.P. Morgan Chases' "demands for collateral and modifications to agreements...that hurt Lehman's liquidity...."

CLASSROOM APPLICATION: The questions ask students to understand repurchase agreements and cases in which financing (borrowing) transactions might alternatively be treated as sales. The role of the auditor, in this case Ernst & Young, also is highlighted in the article and in the questions in this review.

QUESTIONS: 
1. (Introductory) What report was issued in March 2010 regarding Lehman Brothers? Summarize some main points about the report.

2. (Advanced) Based on the discussion in the main and first related articles, describe the "repo market'. What is the business purpose of these transactions?

3. (Advanced) How did Lehman Brothers use repo transactions to improve its balance sheet? Note: be sure to refer to the related articles as some points in the main article emphasize the impact of removing the assets that are subject to the repo agreements from the balance sheet. The main point of your discussion should focus on what else might have been credited in the entries to record these transactions.

4. (Introductory) Refer to the second related article. What was the role of Lehman's auditor in assessing the repo transactions? What questions have been asked of this firm and how has E&Y responded?

Reviewed By: Judy Beckman, University of Rhode Island

RELATED ARTICLES: 
Lehman Maneuver Raises Accounting Question.
by David Reilly
Mar 13, 2010
Online Exclusive

 

"Examiner: Lehman Torpedoed Lehman," by: Mike Spector, Susanne Craig, Peter Lattman, The Wall Street Journal, Mar 11, 2010 ---
http://online.wsj.com/article/SB10001424052748703625304575115963009594440.html?mod=djem_jiewr_AC_domainid

A scathing report by a U.S. bankruptcy-court examiner investigating the collapse of Lehman Brothers Holdings Inc. blames senior executives and auditor Ernst & Young for serious lapses that led to the largest bankruptcy in U.S. history and the worst financial crisis since the Great Depression.

In the works for more than a year, and costing more than $30 million, the report by court-appointed examiner Anton Valukas paints the most complete picture yet of the free-wheeling culture inside the 158 year-old firm, whose chief executive Richard S. Fuld Jr. prided himself on his ability to manage market risk.

The document runs thousands of pages and contains fresh allegations. In particular, it alleges that Lehman executives manipulated its balance sheet, withheld information from the board, and inflated the value of toxic real estate assets.

Lehman chose to "disregard or overrule the firm's risk controls on a regular basis,'' even as the credit and real-estate markets were showing signs of strain, the report said.

In one instance from May 2008, a Lehman senior vice president alerted management to potential accounting irregularities, a warning the report says was ignored by Lehman auditors Ernst & Young and never raised with the firm's board.

The allegations of accounting manipulation and risk-control abuses potentially could influence pending criminal and civil investigations into Lehman and its executives. The Manhattan and Brooklyn U.S. attorney's offices are investigating, among other things, whether former Lehman executives misled investors about the firm's financial picture before it filed for bankruptcy protection, and whether Lehman improperly valued its real-estate assets, people familiar with the matter have said.

The examiner said in the report that throughout the investigation it conducted regular weekly calls with the Securities and Exchange Commission and Department of Justice. There have been no prosecutions of Lehman executives to date.

Several factors helped to tip Lehman over the brink in its final days, Mr. Valukas wrote. Investment banks, including J.P. Morgan Chase & Co., made demands for collateral and modified agreements with Lehman that hurt Lehman's liquidity and pushed it into bankruptcy.

Lehman's own global financial controller, Martin Kelly, told the examiner that "the only purpose or motive for the transactions was reduction in balance sheet" and "there was no substance to the transactions." Mr. Kelly said he warned former Lehman finance chiefs Erin Callan and Ian Lowitt about the maneuver, saying the transactions posed "reputational risk" to Lehman if their use became publicly known.

In an interview with the examiner, senior Lehman Chief Operating Officer Bart McDade said he had detailed discussions with Mr. Fuld about the transactions and that Mr. Fuld knew about the accounting treatment.

In an April 2008 email, Mr. McDade called such accounting maneuvers "another drug we r on." Mr. McDade, then Lehman's equities chief, says he sought to limit such maneuvers, according to the report. Mr. McDade couldn't be reached to comment.

In a November 2009 interview with the examiner, Mr. Fuld said he had no recollection of Lehman's use of Repo 105 transactions but that if he had known about them he would have been concerned, according to the report.

Mr. Valukas's report is among the largest undertaking of its kind. Those singled out in the report won't face immediate repercussions. Rather, the report provides a type of road map for Lehman's bankruptcy estate, creditors and other authorities to pursue possible actions against former Lehman executives, the bank's auditors and others involved in the financial titan's collapse.

One party singled out in the report is Lehman's audit firm, Ernst & Young, which allegedly didn't raise concerns with Lehman's board about the frequent use of the repo transactions. E&Y met with Lehman's Board Audit Committee on June 13, one day after Lehman senior vice president Matthew Lee raised questions about the frequent use of the transactions.

"Ernst & Young took no steps to question or challenge the nondisclosure by Lehman of its use of $50 billion of temporary, off-balance sheet transactions," Mr. Valukas wrote.

In a statement, Mr. Fuld's lawyer, Patricia Hynes, said, "Mr. Fuld did not know what those transactions were—he didn't structure or negotiate them, nor was he aware of their accounting treatment."

An Ernst & Young statement Thursday said Lehman's collapse was caused by "a series of unprecedented adverse events in the financial markets." It said Lehman's leverage ratios "were the responsibility of management, not the auditor."

Ms. Callan didn't respond to a request for comment. An attorney for Mr. Lowitt said any suggestion he breached his duties was "baseless." Mr. Kelly couldn't be reached Thursday evening.

As Lehman began to unravel in mid-2008, investors began to focus their attention on the billions of dollars in commercial real estate and private-equity loans on Lehman's books.

The report said that while Lehman was required to report its inventory "at fair value," a price it would receive if the asset were hypothetically sold, Lehman "progressively relied on its judgment to determine the fair value of such assets."

Between December 2006 and December 2007, Lehman tripled its firmwide risk appetite.

But its risk exposure was even larger, according to the report, considering that Lehman omitted "some of its largest risks from its risk usage calculations" including the $2.3 billion bridge equity loan it provided for Tishman Speyer's $22.2 billion take over of apartment company Archstone Smith Trust. The late 2007 deal, which occurred as the commercial-property market was cresting, led to big losses for Lehman.

Lehman eventually added the Archstone loan to its risk usage profile. But rather than reducing its balance sheet to compensate for the additional risk, it simply raised its risk limit again, the report said.

Bob Jensen's threads on the Lehman financial and accounting fraud are at
http://faculty.trinity.edu/rjensen/fraud001.htm#Ernst

Where Were the Auditors?
http://faculty.trinity.edu/rjensen/2008Bailout.htm#AuditFirms

Watch the video! (a bit slow loading)
Lynn Turner is Partnoy's co-author of the white paper."Make Markets Be Markets"
"Bring Transparency to Off-Balance Sheet Accounting," by Frank Partnoy, Roosevelt Institute, March 2010 ---
http://www.rooseveltinstitute.org/policy-and-ideas/ideas-database/bring-transparency-balance-sheet-accounting
Watch the video!

Abusive off-balance sheet accounting was a major cause of the financial crisis.  These abuses triggered a daisy chain of dysfunctional decision-making by removing transparency from investors, markets, and regulators.  Off-balance sheet accounting facilitating the spread of the bad loans, securitizations, and derivative transactions that brought the financial system to the brink of collapse.

As in the 1920s, the balance sheets of major corporations recently failed to provide a clear picture of the financial health of those entities.  Banks in particular have become predisposed to narrow the size of their balance sheets, because investors and regulators use the balance sheet as an anchor in their assessment of risk.  Banks use financial engineering to make it appear that they are better capitalized and less risky than they really are.  Most people and businesses include all of their assets and liabilities on their balance sheets.  But large financial institutions do not.

Click here to read the full chapter.---
http://www.rooseveltinstitute.org/sites/all/files/Off-Balance Sheet Transactions.pdf

Frank Partnoy is the George E. Barnett Professor of Law and Finance and is the director of the Center on Coporate and Securities Law at the University of San Diego.  He worked as a derivatives structurer at Morgan Stanley and CS First Boston during the mid-1990s and wrote F.I.A.S.C.O.: Blook in the Water on Wall Street, a best-selling book about his experiences there.  His other books include Infectious Greed: How Deceit and Risk Corrupted the Financial Markets and The Match King: Ivar Kreuger, The Financial Genius Behind a Century of Wall Street Scandals.

Lynn Turner has the unique perspective of having been the Chief Accountant of the Securities and Exchange Commission, a member of boards of public companies, a trustee of a mutual fund and a public pension fund, a professor of accounting, a partner in one of the major international auditing firms, the managing director of a research firm and a chief financial officers and an executive in industry.  In 2007, Treasury Secretary Paulson appointed him to the Treasury Committee on the Auditing Profession.  He currently serves as a senior advisor to LECG, an international forensics and economic consulting firm.

The views expressed in this paper are those of the authors and do not necessarily reflect the positions of the Roosevelt Institute, its officers, or its directors. 

Bob Jensen's threads on OBSF are at
http://faculty.trinity.edu/rjensen/theory01.htm#OBSF2

For over 15 years Frank Partnoy has been appealing in vain for financial reform. My timeline of history of the scandals, the new accounting standards, and the new ploys at OBSF and earnings management is at
http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds

My Hero Lawyer, Professor, and Wall Street Financial Expert Weighs In


Question
In the bankruptcy court examiner's report on Lehman's downfall, is Volume 3 more or less important than Volume 2?

Answer
For Ernst & Young it is probably Volume 3, but my true hero exposing Wall Street scandals opts for Volume 2.

My favorite Wall Street books exposing the inside greed and fraud on Wall Street are those written by Frank Partnoy. My timeline of his exposes can be found at http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds .

Professor Partnoy's Senate Testimony was among the first solid explanations of how derivative financial instruments frauds took place at Enron. His entire testimony can be found at http://faculty.trinity.edu/rjensen/FraudEnron.htm#FrankPartnoyTestimony
See his explanation of the infamous Footnote 16 of the Year 2000 Enron Annual report ---
http://faculty.trinity.edu/rjensen/FraudEnron.htm#Senator

His books are among the funniest and best books I've ever read in my life, even better than the books of Michael Lewis.
http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
They are the most dog-eared and scruffed up books in my entire library.

"Lehman Examiner Punted on Valuation,"
by Frank Partnoy, Professor of Law and Finance University of San Diego School of Law and author of Fiasco, Infectious Greed, and The Match King
Naked Capitalism, March 14, 2010 ---
http://www.nakedcapitalism.com/2010/03/frank-partnoy-lehman-examiner-punted-on-valuation.html

The buzz on the Lehman bankruptcy examiner’s report has focused on Repo 105, for good reason. That scheme is one powerful example of how the balance sheets of major Wall Street banks are fiction. It also shows why Congress must include real accounting reform in its financial legislation, or risk another collapse. (If you have 8 minutes to kill, here is my recent talk on the off-balance sheet problem, from the Roosevelt Institute financial conference.)

But an even more troubling section of the Lehman report is not Volume 3 on Repo 105. It is Volume 2, on Valuation. The Valuation section is 500 pages of utterly terrifying reading. It shows that, even eighteen months after Lehman’s collapse, no one – not the bankruptcy examiner, not Lehman’s internal valuation experts, not Ernst and Young, and certainly not the regulators – could figure out what many of Lehman’s assets and liabilities were worth. It shows Lehman was too complex to do anything but fail.

The report cites extensive evidence of valuation problems. Check out page 577, where the report concludes that Lehman’s high credit default swap valuations were reasonable because Citigroup’s marks were ONLY 8% lower than Lehman’s. 8%? And since when are Citigroup’s valuations the objective benchmark?

Or page 547, where the report describes how Lehman’s so-called “Product Control Group” acted like Keystone Kops: the group used third-party prices for only 10% of Lehman’s CDO positions, and deferred to the traders’ models, saying “We’re not quants.” Here are two money quotes:

While the function of the Product Control Group was to serve as a check on the
desk marks set by Lehman’s traders, the CDO product controllers were hampered in
two respects. First, the Product Control Group did not appear to have sufficient
resources to price test Lehman’s CDO positions comprehensively. Second, while the
CDO product controllers were able to effectively verify the prices of many positions
using trade data and third‐party prices, they did not have the same level of quantitative sophistication as many of the desk personnel who developed models to price CDOs. (page 547)

Or this one:

However, approximately a quarter of Lehman’s CDO positions were not affirmatively priced by the Product Control Group, but simply noted as ‘OK’ because the desk had already written down the position significantly. (page 548)

My favorite section describes the valuation of Ceago, Lehman’s largest CDO position. My corporate finance students at the University of San Diego School of Law understand that you should use higher discount rates for riskier projects. But the Valuation section of the report found that with respect to Ceago, Lehman used LOWER discount rates for the riskier tranches than for the safer ones:

The discount rates used by Lehman’s Product Controllers were significantly understated. As stated, swap rates were used for the discount rate on the Ceago subordinate tranches. However, the resulting rates (approximately 3% to 4%) were significantly lower than the approximately 9% discount rate used to value the more senior S tranche. It is inappropriate to use a discount rate on a subordinate tranche that is lower than the rate used on a senior tranche. (page 556)

It’s one thing to have product controllers who aren’t “quants”; it’s quite another to have people in crucial risk management roles who don’t understand present value.

When the examiner compared Lehman’s marks on these lower tranches to more reliable valuation estimates, it found that “the prices estimated for the C and D tranches of Ceago securities are approximately one‐thirtieth of the price reported by Lehman. (pages 560-61) One thirtieth? These valuations weren’t even close.

Ultimately, the examiner concluded that these problems related to only a small portion of Lehman’s overall portfolio. But that conclusion was due in part to the fact that the examiner did not have the time or resources to examine many of Lehman’s positions in detail (Lehman had 900,000 derivative positions in 2008, and the examiner did not even try to value Lehman’s numerous corporate debt and equity holdings).

The bankruptcy examiner didn’t see enough to bring lawsuits. But the valuation section of the report raises some hot-button issues for private parties and prosecutors. As the report put it, there are issues that “may warrant further review by parties in interest.”

For example, parties in interest might want to look at the report’s section on Archstone, a publicly traded REIT Lehman acquired in October 2007. Much ink has been spilled criticizing the valuation of Archstone. Here is the Report’s finding (at page 361):

… there is sufficient evidence to support a finding that Lehman’s valuations for its Archstone equity positions were unreasonable beginning as of the end of the first quarter of 2008, and continuing through the end of the third quarter of 2008.

And Archstone is just one of many examples.

The Repo 105 section of the Lehman report shows that Lehman’s balance sheet was fiction. That was bad. The Valuation section shows that Lehman’s approach to valuing assets and liabilities was seriously flawed. That is worse. For a levered trading firm, to not understand your economic position is to sign your own death warrant.

The End of Wall Street?

Liars Poker II is called "The End"
The Not-Funny Punch Line is Not Until Page 9 of This Tongue in Cheek Explanation of the Meltdown on Wall Street!

Now I asked Gutfreund about his biggest decision. “Yes,” he said. “They—the heads of the other Wall Street firms—all said what an awful thing it was to go public (beg for a government bailout) and how could you do such a thing. But when the temptation arose, they all gave in to it.” He agreed that the main effect of turning a partnership into a corporation was to transfer the financial risk to the shareholders. “When things go wrong, it’s their problem,” he said—and obviously not theirs alone. When a Wall Street investment bank screwed up badly enough, its risks became the problem of the U.S. government. “It’s laissez-faire until you get in deep shit,” he said, with a half chuckle. He was out of the game.

This is a must read to understand what went wrong on Wall Street --- especially the punch line!
"The End," by Michael Lewis December 2008 Issue The era that defined Wall Street is finally, officially over. Michael Lewis, who chronicled its excess in Liar’s Poker, returns to his old haunt to figure out what went wrong.
http://www.portfolio.com/news-markets/national-news/portfolio/2008/11/11/The-End-of-Wall-Streets-Boom?tid=true

To this day, the willingness of a Wall Street investment bank to pay me hundreds of thousands of dollars to dispense investment advice to grownups remains a mystery to me. I was 24 years old, with no experience of, or particular interest in, guessing which stocks and bonds would rise and which would fall. The essential function of Wall Street is to allocate capital—to decide who should get it and who should not. Believe me when I tell you that I hadn’t the first clue.

I’d never taken an accounting course, never run a business, never even had savings of my own to manage. I stumbled into a job at Salomon Brothers in 1985 and stumbled out much richer three years later, and even though I wrote a book about the experience, the whole thing still strikes me as preposterous—which is one of the reasons the money was so easy to walk away from. I figured the situation was unsustainable. Sooner rather than later, someone was going to identify me, along with a lot of people more or less like me, as a fraud. Sooner rather than later, there would come a Great Reckoning when Wall Street would wake up and hundreds if not thousands of young people like me, who had no business making huge bets with other people’s money, would be expelled from finance.

When I sat down to write my account of the experience in 1989—Liar’s Poker, it was called—it was in the spirit of a young man who thought he was getting out while the getting was good. I was merely scribbling down a message on my way out and stuffing it into a bottle for those who would pass through these parts in the far distant future.

Unless some insider got all of this down on paper, I figured, no future human would believe that it happened.

I thought I was writing a period piece about the 1980s in America. Not for a moment did I suspect that the financial 1980s would last two full decades longer or that the difference in degree between Wall Street and ordinary life would swell into a difference in kind. I expected readers of the future to be outraged that back in 1986, the C.E.O. of Salomon Brothers, John Gutfreund, was paid $3.1 million; I expected them to gape in horror when I reported that one of our traders, Howie Rubin, had moved to Merrill Lynch, where he lost $250 million; I assumed they’d be shocked to learn that a Wall Street C.E.O. had only the vaguest idea of the risks his traders were running. What I didn’t expect was that any future reader would look on my experience and say, “How quaint.”

I had no great agenda, apart from telling what I took to be a remarkable tale, but if you got a few drinks in me and then asked what effect I thought my book would have on the world, I might have said something like, “I hope that college students trying to figure out what to do with their lives will read it and decide that it’s silly to phony it up and abandon their passions to become financiers.” I hoped that some bright kid at, say, Ohio State University who really wanted to be an oceanographer would read my book, spurn the offer from Morgan Stanley, and set out to sea.

Somehow that message failed to come across. Six months after Liar’s Poker was published, I was knee-deep in letters from students at Ohio State who wanted to know if I had any other secrets to share about Wall Street. They’d read my book as a how-to manual.

In the two decades since then, I had been waiting for the end of Wall Street. The outrageous bonuses, the slender returns to shareholders, the never-ending scandals, the bursting of the internet bubble, the crisis following the collapse of Long-Term Capital Management: Over and over again, the big Wall Street investment banks would be, in some narrow way, discredited. Yet they just kept on growing, along with the sums of money that they doled out to 26-year-olds to perform tasks of no obvious social utility. The rebellion by American youth against the money culture never happened. Why bother to overturn your parents’ world when you can buy it, slice it up into tranches, and sell off the pieces?

At some point, I gave up waiting for the end. There was no scandal or reversal, I assumed, that could sink the system.

The New Order The crash did more than wipe out money. It also reordered the power on Wall Street. What a Swell Party A pictorial timeline of some Wall Street highs and lows from 1985 to 2007. Worst of Times Most economists predict a recovery late next year. Don’t bet on it. Then came Meredith Whitney with news. Whitney was an obscure analyst of financial firms for Oppenheimer Securities who, on October 31, 2007, ceased to be obscure. On that day, she predicted that Citigroup had so mismanaged its affairs that it would need to slash its dividend or go bust. It’s never entirely clear on any given day what causes what in the stock market, but it was pretty obvious that on October 31, Meredith Whitney caused the market in financial stocks to crash. By the end of the trading day, a woman whom basically no one had ever heard of had shaved $369 billion off the value of financial firms in the market. Four days later, Citigroup’s C.E.O., Chuck Prince, resigned. In January, Citigroup slashed its dividend.

From that moment, Whitney became E.F. Hutton: When she spoke, people listened. Her message was clear. If you want to know what these Wall Street firms are really worth, take a hard look at the crappy assets they bought with huge sums of ­borrowed money, and imagine what they’d fetch in a fire sale. The vast assemblages of highly paid people inside the firms were essentially worth nothing. For better than a year now, Whitney has responded to the claims by bankers and brokers that they had put their problems behind them with this write-down or that capital raise with a claim of her own: You’re wrong. You’re still not facing up to how badly you have mismanaged your business.

Rivals accused Whitney of being overrated; bloggers accused her of being lucky. What she was, mainly, was right. But it’s true that she was, in part, guessing. There was no way she could have known what was going to happen to these Wall Street firms. The C.E.O.’s themselves didn’t know.

Now, obviously, Meredith Whitney didn’t sink Wall Street. She just expressed most clearly and loudly a view that was, in retrospect, far more seditious to the financial order than, say, Eliot Spitzer’s campaign against Wall Street corruption. If mere scandal could have destroyed the big Wall Street investment banks, they’d have vanished long ago. This woman wasn’t saying that Wall Street bankers were corrupt. She was saying they were stupid. These people whose job it was to allocate capital apparently didn’t even know how to manage their own.

At some point, I could no longer contain myself: I called Whitney. This was back in March, when Wall Street’s fate still hung in the balance. I thought, If she’s right, then this really could be the end of Wall Street as we’ve known it. I was curious to see if she made sense but also to know where this young woman who was crashing the stock market with her every utterance had come from.

It turned out that she made a great deal of sense and that she’d arrived on Wall Street in 1993, from the Brown University history department. “I got to New York, and I didn’t even know research existed,” she says. She’d wound up at Oppenheimer and had the most incredible piece of luck: to be trained by a man who helped her establish not merely a career but a worldview. His name, she says, was Steve Eisman.

Eisman had moved on, but they kept in touch. “After I made the Citi call,” she says, “one of the best things that happened was when Steve called and told me how proud he was of me.”

Having never heard of Eisman, I didn’t think anything of this. But a few months later, I called Whitney again and asked her, as I was asking others, whom she knew who had anticipated the cataclysm and set themselves up to make a fortune from it. There’s a long list of people who now say they saw it coming all along but a far shorter one of people who actually did. Of those, even fewer had the nerve to bet on their vision. It’s not easy to stand apart from mass hysteria—to believe that most of what’s in the financial news is wrong or distorted, to believe that most important financial people are either lying or deluded—without actually being insane. A handful of people had been inside the black box, understood how it worked, and bet on it blowing up. Whitney rattled off a list with a half-dozen names on it. At the top was Steve Eisman.

Steve Eisman entered finance about the time I exited it. He’d grown up in New York City and gone to a Jewish day school, the University of Pennsylvania, and Harvard Law School. In 1991, he was a 30-year-old corporate lawyer. “I hated it,” he says. “I hated being a lawyer. My parents worked as brokers at Oppenheimer. They managed to finagle me a job. It’s not pretty, but that’s what happened.”

He was hired as a junior equity analyst, a helpmate who didn’t actually offer his opinions. That changed in December 1991, less than a year into his new job, when a subprime mortgage lender called Ames Financial went public and no one at Oppenheimer particularly cared to express an opinion about it. One of Oppenheimer’s investment bankers stomped around the research department looking for anyone who knew anything about the mortgage business. Recalls Eisman: “I’m a junior analyst and just trying to figure out which end is up, but I told him that as a lawyer I’d worked on a deal for the Money Store.” He was promptly appointed the lead analyst for Ames Financial. “What I didn’t tell him was that my job had been to proofread the ­documents and that I hadn’t understood a word of the fucking things.”

Ames Financial belonged to a category of firms known as nonbank financial institutions. The category didn’t include J.P. Morgan, but it did encompass many little-known companies that one way or another were involved in the early-1990s boom in subprime mortgage lending—the lower class of American finance.

The second company for which Eisman was given sole responsibility was Lomas Financial, which had just emerged from bankruptcy. “I put a sell rating on the thing because it was a piece of shit,” Eisman says. “I didn’t know that you weren’t supposed to put a sell rating on companies. I thought there were three boxes—buy, hold, sell—and you could pick the one you thought you should.” He was pressured generally to be a bit more upbeat, but upbeat wasn’t Steve Eisman’s style. Upbeat and Eisman didn’t occupy the same planet. A hedge fund manager who counts Eisman as a friend set out to explain him to me but quit a minute into it. After describing how Eisman exposed various important people as either liars or idiots, the hedge fund manager started to laugh. “He’s sort of a prick in a way, but he’s smart and honest and fearless.”

“A lot of people don’t get Steve,” Whitney says. “But the people who get him love him.” Eisman stuck to his sell rating on Lomas Financial, even after the company announced that investors needn’t worry about its financial condition, as it had hedged its market risk. “The single greatest line I ever wrote as an analyst,” says Eisman, “was after Lomas said they were hedged.” He recited the line from memory: “ ‘The Lomas Financial Corp. is a perfectly hedged financial institution: It loses money in every conceivable interest-rate environment.’ I enjoyed writing that sentence more than any sentence I ever wrote.” A few months after he’d delivered that line in his report, Lomas Financial returned to bankruptcy.

Continued in article

Michael Lewis, Liar's Poker: Playing the Money Markets (Coronet, 1999, ISBN 0340767006)

Lewis writes in Partnoy’s earlier whistleblower style with somewhat more intense and comic portrayals of the major players in describing the double dealing and break down of integrity on the trading floor of Salomon Brothers.

Continued at http://faculty.trinity.edu/rjensen/FraudRotten.htm

"Public Pensions Cook the Books:  Some plans want to hide the truth from taxpayers," by Andrew Biggs, The Wall Street Journal, July 6, 2009 --- http://online.wsj.com/article/SB124683573382697889.html

"Dirty Secrets:  Companies may be burying billions more in environmental liabilities than their financial statements show," by Marie Leone and Tim Reason, CFO.com, September 1, 2009 ---
http://www.cfo.com/article.cfm/14292477/c_14292723?f=magazine_featured

Today the financial world is up in arms over "toxic assets," the bad loans and securities that have wreaked so much havoc on bank balance sheets. But few investors understand the true magnitude of the threat that toxic liabilities — environmental liabilities, that is — pose to the financial health of some U.S. businesses. In large part that's because accounting rules enable companies to conceal the full extent of these costs, encouraging minimal disclosure — even when management knows the total bill will be far higher.

It's no secret that many companies have expensive toxic liabilities — asbestos, heavy-metal pollution, oil and gas leaks, contaminated groundwater, and more. Since the 1970s, Superfund and other laws have required companies to clean up their environmental liabilities and undo the damage they caused. Nor is the primary accounting guidance for toxic liabilities new. FAS 5, the accounting standard governing so-called contingent liabilities, such as pending litigation and environmental hazards, went into effect in 1975; Statement of Position 96-1, which tells firms how to apply FAS 5 to mandated environmental remediation, was issued in 1996. In brief, companies with toxic liabilities must take a one-time charge to earnings and create a reserve of funds devoted to environmental remediation. As a cleanup progresses, the reserve should shrink.

Yet companies are regularly topping up their environmental reserves with new accruals. Some reserves are even growing. In a recent study of 24 oil, gas, and chemical companies, the vast majority reduced their reserves less than 50 cents for each dollar spent on cleanup, says environmental attorney Greg Rogers, a CPA and president of consulting firm Advanced Environmental Dimensions. (See "The Truth about Reserves" at the end of this article.)

As a result, investors are left in the dark about the full extent of toxic liabilities. Rogers compares environmental reserves to a bathtub full of water: once the environmental problems are resolved, the tub should be drained. But by adding new accruals each year, companies are effectively leaving the faucet on. "What we don't know is the true capacity of the tub, the cost to fully resolve these liabilities," says Rogers, whose study attempts to estimate those costs using publicly available data.

Whatever a never-ending cleanup bill implies about actual damage done to the environment, such recurring drains on cash flow certainly hurt investors. "Unlike nearly every other income-statement line item, there is very little if any visibility into the annual charge for 'probable and reasonably estimable environmental liabilities,'" complained JPMorgan analyst Stephen Tusa, who downgraded Honeywell for this reason in 2006.

"It's Scandalous." Companies typically cite three reasons why their legacy cleanup reserves never drain: the difficulty of estimating cleanup costs, new discoveries of contamination, or new costs acquired through mergers. At some companies, however, those claims are belied by the steady rate at which they funnel money into environmental reserves, suggesting, critics say, that managerial discretion plays a large part in reserve calculations. (One company, ConAgra, paid $45 million in 2007 to settle Securities and Exchange Commission charges that it used environmental reserves as a "cookie jar.") At best, the explanations mean that companies are themselves blind to a major internal drain on cash.

Despite what companies say, it isn't difficult to accurately estimate the future cost of environmental liabilities, asserts Gayle Koch, a principal with The Brattle Group in Cambridge, Massachusetts. Koch says her firm regularly does so for both corporate and government clients. "Companies estimate liabilities all the time for insurance recovery, to get insurance, for mergers and acquisitions, and in divestitures," she says. "Transactions go forward based on those estimates." The problem isn't the estimates, she says, but the disclosure.

"I've been in court cases where I've seen detailed cost recovery with very detailed distributions of costs," says Koch. "And those same companies will disclose in their annual reports [only] the known minimum cost."

Sanford Lewis, an attorney with the Investor Environmental Health Network (IEHN), an advocacy group, agrees that companies can and do produce accurate estimates of environmental costs — for internal use. A company that tells investors that it expects liabilities of $200 million during the next 5 years may advise its insurer to expect liability claims of $2 billion over a 50-year period, wrote Lewis in a recent report. "It is happening, it's scandalous, and investors should be outraged," Lewis told CFO.

Increasingly, lawsuits, bankruptcy proceedings, regulatory investigations, and independent research are revealing that companies often know far more about the cost of their environmental liabilities than they tell investors. For example, New York Attorney General Andrew Cuomo is currently investigating whether Chevron misled investors — including New York State's pension plan — about the extent of its liability in a $27 billion lawsuit tied to "massive oil seepage" in Ecuador. Chevron is widely expected to lose the case in Ecuador but fight payment in the United States, and Cuomo has demanded that the company disclose estimates of potential damages and its cash reserves.

Continued in article

Bob Jensen's fraud updates are at http://faculty.trinity.edu/rjensen/FraudUpdates.htm